Tuesday, July 31, 2012

Fire Ed DeMarco, by Paul Krugman: Do it now. ... DeMarco heads the Federal Housing Finance Agency, which oversees Fannie and Freddie. And he has just rejected a request from the Treasury Department that he offer debt relief to troubled homeowners — a request backed by an offer by Treasury to pay up to 63 cents to the FHFA for every dollar of debt forgiven.

DeMarco’s basis for the rejection was that this forgiveness would represent a net loss to taxpayers, even if his agency came out ahead.

That’s a very arguable point even on its own terms, because the paper he cited (pdf) in support of his stance took no account of the positive effects on the economy of debt relief — even though those effects are the main reason for offering such relief. ... Furthermore, even if there’s a small net cost to taxpayers, debt relief is still worth doing if it yields large economic benefits.

In any case, however, deciding whether debt relief is a good policy for the nation as a whole is not DeMarco’s job. His job — as long as he keeps it, which I hope is a very short period of time — is to run his agency. If the Secretary of the Treasury, acting on behalf of the president, believes that it is in the national interest to spend some taxpayer funds on debt relief, in a way that actually improves the FHFA’s budget position, the agency’s director has no business deciding on his own that he prefers not to act.

I don’t know what DeMarco’s specific legal mandate is. But there is simply no way that it makes sense for an agency director to use his position to block implementation of the president’s economic policy, not because it would hurt his agency’s operations, but simply because he disagrees with that policy.

This guy needs to go.

If households can't get help repairing their balance sheets, then the recovery from the balance sheet recession -- such as it is -- will be even slower. Banks got the help they needed with their balance sheet problems, but households have not received as much attention.

Brad DeLong also has a column today (and I no longer have this complaint):

Hopeless Unemployment, by Brad DeLong, Commentary, Project Syndicate: ...At first, the long-term unemployed in the Great Depression searched eagerly and diligently for alternative sources of work. But, after six months or so passed without successful reemployment, they tended to become discouraged and distraught. After 12 months of continuous unemployment, the typical unemployed worker still searched for a job, but in a desultory fashion, without much hope. And, after two years of unemployment, the worker, accurately expecting to be at the end of every hiring queue, had lost hope and, for all practical purposes, left the labor market.

This was the pattern of the long-term unemployed in the Great Depression. It was also the pattern of the long-term unemployed in Western Europe at the end of the 1980s. And, in a year or two, it will be the pattern again for the long-term unemployed in the North Atlantic region.

I have been arguing for four years that our business-cycle problems call for more aggressively expansionary monetary and fiscal policies, and that our biggest problems would quickly melt away were such policies to be adopted. That is still true. But, over the next two years, barring a sudden and unexpected interruption of current trends, it will become less true.

The current balance of probabilities is that two years from now, the North Atlantic’s principal labor-market failures will not be demand-side market failures that could be easily remedied by more aggressive policies to boost economic activity and employment. Rather, they will be structural market failures of participation that are not amenable to any straightforward and easily implemented cure.

Unwavering Republican commitment to lower taxes and smaller government -- policies favored by wealthy campaign backers -- makes it impossible for Congress to do more to help middle and lower class households struggling with the recession.

Quick Euro Update, by Tim Duy: Mostly quiet on the Euro front today, but there are some bits and pieces worth chewing over. To recap, ECB President Mario Draghi raised expectations that a big plan was in the works to save the Euro. In short, Draghi's commitment to do everything necessary to save the Euro was interpretted to mean that the ECB was prepared to act as a lender of last resort to bring down yields in struggling periphery nations.

There is an alternative explanation. Draghi was simply making some off-the-cuff remarks, saying things he thought he largely said before, and not intending to illicit the subsequent market response. If so, market participants may be set up for a phenomenal dissapointment this week.

It was an illustrious meeting that British Prime Minister David Cameron was hosting on the evening before the opening of the Olympic Games in London...

...It was meant to be a day of glamour, but then Mario Draghi, the president of the European Central Bank (ECB), made a seemingly trivial remark -- but one that ensured that the 200 prominent guests were swiftly brought back to gloomy reality. His organization, he promised, would do "whatever it takes to preserve the euro."

The audience treated the remark as just another platitude coming from a politician. But International financial traders understood it as an announcement that the ECB was about to buy up Italian and Spanish government bonds in a big way. So they did what they always do when central banks suggest they might soon be firing up the money-printing presses: They clicked on the "buy" button...

...Meanwhile, experts at the central banks of the euro zone's 17 member states had no idea what to do with the news. Draghi's remark was not the result of any resolutions, and even members of the ECB Governing Council admitted that they had heard nothing of such plans until then.

This doesn't sound like Draghi has much time to build a concensus. Interestingly, Spiegel claims that the pressure on Draghi is becoming unbearable:

A deep-seated feeling of mistrust has taken hold at Frankfurt's Eurotower, the ECB's headquarters, and even Draghi, who is normally seen as the epitome of level-headedness among central bankers, has recently shown signs of nervousness. At a dinner in early July, the ECB chief and his fellow governors were discussing the question of whether the ECB's loans to Ireland's government-owned "bad bank" were consistent with the bank's current bylaws.

It was a debate among experts, like many before it, but then something unusual happened: Draghi raised his voice. Such questions, he snapped at his opponents, could not always be discussed in exclusively legal terms...

...The ECB president has become thin-skinned and easily irritated by criticism, especially when it comes from Germany.

Sounds like ECB is coming apart at the seems, much like Europe itself. The story that Draghi was interested in downplaying "legal concerns" is particularly interesting. It suggests that he increasingly does not believe he can save the Euro in the context of strict interpretations of the ECB's mandate.

Both the ECB and the Fed are set to meet this week. The Fed will start a two-day meeting on Tuesday, with many economists believing the central bank will wait until September to provide more stimulus to a faltering U.S. economic recovery. The ECB's policy-setting meeting on Thursday is receiving more of the markets' attention after the bank's chief, Mario Draghi, pledged last week to do everything to save the euro.

But translating his words into action are particularly important given the threat the long-running euro zone crisis poses to the global economy.

Bold action by the ECB is at least five weeks away, insiders told Reuters.

I would really appreciate a little expansion on that last line. The longer timeline would not be surprising if the Spiegel report is correct and Draghi failed to build consensus before he spoke.

Finally, on the issue of convertibility and default risk, Joseph Cotterill at FT Alphaville says:

The ECB could now see a risk to its monetary policy — conducted in euros — from market pricing of peripheral bonds which assumes they won’t eventually be paid back in euros. And it could now act on this risk. However it might do this and with whatever facilities, it feels conceptually different to the actions which the market largely expects, which are versions of credit easing or liquidity for sovereign debt (the SMP).

FT Alphaville sees this as more about convertibility than default risk, different than I suggested yesterday. I think though that we both agree this may be crucial to understanding Draghi's policy intentions. Cotterill also cites research on quantifying this risk, and thus what the ECB is prepared to do. maybe less than the market expects. I think following FT Alphaville on this subject (and many more, of course) is well worth the time.

Bottom Line: Seems like a lot of uncertainty heading into this ECB meeting, despite financial market participant's understandably crystal-clear interpretation of Draghi's now famous remarks.

New Old Keynesians: There is no grand, unifying theoretical structure in economics. We do not have one model that rules them all. Instead, what we have are models that are good at answering some questions - the ones they were built to answer - and not so good at answering others.

If I want to think about inflation in the very long run, the classical model and the quantity theory is a very good guide. But the model is not very good at looking at the short-run. For questions about how output and other variables move over the business cycle and for advice on what to do about it, I find the Keynesian model in its modern form (i.e. the New Keynesian model) to be much more informative than other models that are presently available.

But the New Keynesian model has its limits. It was built to capture "ordinary" business cycles driven by price sluggishness of the sort that can be captured by the Calvo model model of price rigidity. The standard versions of this model do not explain how financial collapse of the type we just witnessed come about, hence they have little to say about what to do about them (which makes me suspicious of the results touted by people using multipliers derived from DSGE models based upon ordinary price rigidities). For these types of disturbances, we need some other type of model, but it is not clear what model is needed. There is no generally accepted model of financial catastrophe that captures the variety of financial market failures we have seen in the past.

But what model do we use? Do we go back to old Keynes, to the 1978 model that Robert Gordon likes, do we take some of the variations of the New Keynesian model that include effects such as financial accelerators and try to enhance those, is that the right direction to proceed? Are the Austrians right? Do we focus on Minsky? Or do we need a model that we haven't discovered yet?

We don't know, and until we do, I will continue to use the model I think gives the best answer to the question being asked. The reason that many of us looked backward to the IS-LM model to help us understand the present crisis is that none of the current models were capable of explaining what we were going through. The models were largely constructed to analyze policy is the context of a Great Moderation, i.e. within a fairly stable environment. They had little to say about financial meltdown. My first reaction was to ask if the New Keynesian model had any derivative forms that would allow us to gain insight into the crisis and what to do about it and, while there were some attempts in that direction, the work was somewhat isolated and had not gone through the type of thorough analysis needed to develop robust policy prescriptions. There was something to learn from these models, but they really weren't up to the task of delivering specific answers. That may come, but we aren't there yet.

So, if nothing in the present is adequate, you begin to look to the past. The Keynesian model was constructed to look at exactly the kinds of questions we needed to answer, and as long as you are aware of the limitations of this framework - the ones that modern theory has discovered - it does provide you with a means of thinking about how economies operate when they are running at less than full employment. This model had already worried about fiscal policy at the zero interest rate bound, it had already thought about Says law, the paradox of thrift, monetary versus fiscal policy, changing interest and investment elasticities in a crisis, etc., etc., etc. We were in the middle of a crisis and didn't have time to wait for new theory to be developed, we needed answers, answers that the elegant models that had been constructed over the last few decades simply could not provide. The Keyneisan model did provide answers. We knew the answers had limitations - we were aware of the theoretical developments in modern macro and what they implied about the old Keynesian model - but it also provided guidance at a time when guidance was needed, and it did so within a theoretical structure that was built to be useful at times like we were facing. I wish we had better answers, but we didn't, so we did the best we could. And the best we could involved at least asking what the Keynesian model would tell us, and then asking if that advice has any relevance today. Sometimes it didn't, but that was no reason to ignore the answers when it did.

[So, depending on the question being asked, I am a New Keynesian, an Old Keynesian, a Classicist, etc. But as noted here, if you are going to take guidance from the older models it is essential that you understand their limitations -- these models should not be used without a thorough knowledge of the pitfalls involved and where they can and cannot be avoided -- the kind of knowledge someone like Paul Krugman surely has at hand.]

Monday, July 30, 2012

The One-Sided Deficit Debate, by James Kwak: Michael Hiltzik ... wrote a column lamenting the domination of the government deficit debate by the wealthy. He clearly has a point. The fact that Simpson-Bowles—which uses its mandate of deficit reduction to call for . . . lower tax rates?—has become widely perceived as a centrist starting-point for discussion is clear evidence of how far to the right the inside-the-Beltway discourse has shifted, both over time and relative to the preferences of the population as a whole.

What’s more, the “consensus” of the self-styled “centrists” is what now makes the Bush tax cuts of 2001 and 2003 seem positively reasonable. With Simpson-Bowles and Domenici-Rivlin both calling for tax rates below those established in 2001, George W. Bush now looks like a moderate; even many Democrats now endorse the Bush tax cuts for families making up to $250,000 per year, which is still a lot of money (for most people, at least).

But some of the blame for this state of affairs must rest with Democrats, liberals, and their usual mouthpieces as well. For over a year now, the refrain of the left-leaning intellectual class has been that the only thing that matters is increasing growth and reducing unemployment, and any discussion of deficits and the national debt plays into the hands of the Republicans. It may be true that jobs should be the top priority right now, but the fact remains that many Americans think that deficits matter (and most of those left-leaning intellectuals would concede that they matter in the long term). Those Americans are currently getting a menu of proposals with Simpson-Bowles in the right, Paul Ryan and Mitt Romney on the far right, and Fox News on the extreme right. There is no explanation of how to deal with our long-term debt problem in a way that preserves government services and social insurance programs and protects the poor and the middle class.

One of my objectives with White House Burning was to help fill that gap, beginning with an explanation of what the federal government does and why it matters and continuing with a proposal for how to fill the long-term budget gap without gutting Social Security, Medicare, and Medicaid. But Simon and I don’t carry a lot of weight with the Serious People who like talking about deficits and shared sacrifice and belt-tightening (not as much as American hero Jamie Dimon, apparently). As long as those people have the floor to themselves, nothing is going to change.

Crash of the Bumblebee, by Paul Krugman, Commentary, NY Times: Last week Mario Draghi, the president of the European Central Bank, declared that his institution “is ready to do whatever it takes to preserve the euro” — and markets celebrated. ... But will the euro really be saved? That remains very much in doubt.

First of all, Europe’s single currency is a deeply flawed construction. And Mr. Draghi, to his credit, actually acknowledged that. “The euro is like a bumblebee,” he declared. “This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years.” But now it has stopped flying. What can be done? The answer, he suggested, is “to graduate to a real bee.”

Never mind the dubious biology, we get the point. In the long run, the euro will be workable only if the European Union becomes much more like a unified country. ...

But ... a United States of Europe won’t happen soon, if ever, while the crisis of the euro is now. So what ... could turn this dangerous situation around? The answer is fairly clear: policy makers would have to (a) do something to bring southern Europe’s borrowing costs down and (b) give Europe’s debtors the same kind of opportunity to export their way out of trouble that Germany received during the good years — that is, create ... a temporary rise in German inflation... The trouble is that Europe’s policy makers seem reluctant to do (a) and completely unwilling to do (b).

In his remarks, Mr. Draghi ... basically floated the idea of having the central bank buy lots of southern European bonds to bring those borrowing costs down. But ... German officials appeared to throw cold water on that idea. In principle, Mr. Draghi could just overrule German objections, but would he really be willing to do that?

And bond purchases are the easy part. The euro can’t be saved unless Germany is also willing to accept substantially higher inflation... — and so far I have seen no sign that German officials are even willing to discuss this issue...

So could the euro be saved? Yes, probably. Should it be saved? Yes, even though its creation now looks like a huge mistake. For failure of the euro wouldn’t just cause economic disruption; it would be a giant blow to the wider European project, which has brought peace and democracy to a continent with a tragic history.

But will it actually be saved? Despite Mr. Draghi’s show of determination, that is, as I said, very much in doubt.

The Euromess Continues, by Tim Duy: Excitement is almost guaranteed this week, with both the Federal Reserve and the European Central Bank pondering their next moves. At the moment, I am more fascinated with the latter, as it represents the more fast moving policy failure for the moment. In response to that disaster to date, it is now widely expected that the ECB will deliver a significant policy expansion, possibly accepting its responsibility of lender of last resort for sovereign debt in the Eurozone. I think it is widely believed that this will be the turning point in Europe. In some ways, yes, as it would keep the threat of imminent dissolution at bay. But the Eurozone will still be fundamentally hobbled by a devotion to re-balancing via austerity-driven internal devaluation. This does not offer a promising long-run outcome.

The sequence of events of last week is becoming clearer. Last Monday, Spanish Economy Minister Luis de Guindos met with his German counterpart. Initial reports indicated no new initiatives were in the works. Subsequent reports suggest otherwise. Friday we learned, via Reuters:

Spain has at last conceded it may need a state bailout and policymakers are considering writing down Greek debt to their central banks, European officials said on Friday, as markets anticipated radical new action to pull the continent out of its debt maelstrom...

...A euro zone official said Economy Minister Luis de Guindos had brought up the prospect of a 300 billion euro bailout this week at a meeting with Germany's Finance Minister Wolfgang Schaeuble. The official spoke on condition of anonymity because he was not authorized to brief

"De Guindos was talking about 300 billion euros for a full program, but Germany was not comfortable with the idea of a bailout now," the official said.

He said the question would be put off until the euro zone's new, permanent bailout fund, the European Stability Mechanism, is up and running. He also said that Germany appeared to be softening its opposition to giving the ESM a banking license, which would allow it to borrow money and deploy more firepower if called upon to rescue an economy as big as Spain's.

So it sounds like de Guindos went to Schaeble with hat in hand, only to be told that at best Spain would need to wait its turn. Meanwhile, market participants, sensing Spain is teetering on the brink, were pummeling the nation's stock and bond markets, sending yields soaring, thus ensuring a bailout was necessary (Interesting aside - at what interest rate does Spain not need a bailout, and would that rate become an ECB target? Sounds like a good project for an investment bank research team.) ECB President Mario Draghi, smelling disaster in the wind, breaks down and delivers some now famous remarks in London, including this line:

To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate.

This indicates Draghi has finally found away around the mandate prohibiting monetizing sovereign debt, laying out the justification for bond purchases as necessary to implement appropriate monetary policy. This generates a massive global relief rally, as everyone and their brother, expect of course apparently everyone at the ECB, knows that only the ECB has the firepower to stop the repeated cycle of panic endured by Europe. It seems like a real, promising plan is in the works. Via Bloomberg:

Draghi’s proposal involves Europe’s rescue funds buying government bonds on the primary market, flanked by ECB purchases on the secondary market to ensure transmission of its record low interest rates, the officials said. Further ECB rate cuts and long-term loans to banks are also up for discussion, one of the officials said.

I don't think Draghi has publicly stated this as a proposal, but instead reporters have pieced this together from contacts within the Eurozone. In any event, to the extent that their exists any substantial opposition to such a plan, that opposition rests with - caution, spoiler alert! - Germany. But you guessed that already, didn't you? Via Reuters:

Germany's Finance Minister dismissed reports Spain is about to ask the euro zone bailout fund to purchase its bonds, and talked down fears about its spiralling borrowing costs in an interview with Welt am Sonntag newspaper made available on Saturday.

"Spain's financing needs in the short-term are not so high. High interest rates are painful and they create a lot of uncertainty, but it is not the end of the world, if you have to pay a few percent more at a few bond auctions," Wolfgang Schaeuble said.

Asked if there was any truth to speculation that Spain would shortly ask the euro zone rescue fund for help via buying its bonds, Schaeuble answered: "No. There is nothing to these speculations."

Germany’s powerful Bundesbank issued a reminder that it still opposed sovereign bond purchases by the European Central Bank, dampening market optimism after ECB president Mario Draghi hinted he could act more decisively in the eurozone debt crisis.

This, I think, is the state of play heading into Monday morning. Basically, Spain is in all-liklihood on the brink of disaster, threatening to drag the rest of the Eurozone with it, Draghi sees this and has made some very, very big promises to deliver imminent action to keep the ship afloat, but he may face internal resistance that necessitates watering down his plans.

Now, at what levels will such a plan work? The short-game here is pretty obvious. It is tough to bet against Spanish or Italian debt if you think the ECB is set to cap borrowing rates. Now think about the long-game. Does it, by itself or in concert with other plans floated in Europe, put the Eurozone economy on firm footing? In my opinion, no. To understand why, one needs to read the full text of Draghi's market-moving remarks.

I struggled with the remarks, and was happy to see that I was not alone. Paul Krugman describes them as strange. I found them downright incomprehensible.

Draghi begins with the analogy that Europe is like a bumblebee. No one believes it should be able to fly, but it did. Then people stopped asking the question of why it should be able to fly until the financial crisis. Now the job is too restore confidence in the Eurozone so that is become a bee, which everyone believes flies.

No, it is not an easy analogy to decipher. But the bottom line seems to be this: There is not anything fundamentally wrong in the Eurozone that prevents a fully functioning economy, it is only a crisis of confidence.

It's not me, it's you.

Draghi then starts the comparisons:

The first message I would like to send, is that the euro is much, much stronger, the euro area is much, much stronger than people acknowledge today. Not only if you look over the last 10 years but also if you look at it now, you see that as far as inflation, employment, productivity, the euro area has done either like or better than US or Japan.

I wish he would quantify these comparisons. Putting that aside, as well as the low bar of Japan and the US in the midst of the most significant economic downturn since the great Depression, Draghi does not seem to realize the importance of capital flows from the core to the periphery. If you don't understand this, you don't understand you need a full on reversal of these flows to keep the Eurozone economy flying. See Paul Krugman.

Not understanding internal capital flows. Strike one for Draghi. He continues:

Then the comparison becomes even more dramatic when we come to deficit and debt. The euro area has much lower deficit, much lower debt than these two countries. And also not less important, it has a balanced current account, no deficits, but it also has a degree of social cohesion that you wouldn’t find either in the other two countries.

So many things wrong here, beginning with the obvious morality play: Debt and deficits are bad, and therefore the Eurozone is stronger than the US or Japan. Again, he fails to recognize the importance of the internal divergence in debt and current account deficits is a driving factor in this crisis. Or, more accurately, that the Eurozone economies are too disparate to function under a single monetary policy.

I don't even know what to say about the social cohesion story. Granted, it has been a decade since closely followed Japan, but, really, Europe has more social cohesion than Japan? The combination of morality play, focusing on the aggregate rather than lack of economic cohesion among the underlying desegregate, and the bizarre appeal to social cohesion is strike two for Draghi.

Draghi anticipates my criticism:

The second point, the second message I would like to send today, is that progress has been extraordinary in the last six months. If you compare today the euro area member states with six months ago, you will see that the world is entirely different today, and for the better.

And this progress has taken different shapes. At national level, because of course, while I was saying, while I was glorifying the merits of the euro, you were thinking “but that’s an average!”, and “in fact countries diverge so much within the euro area, that averages are not representative any longer, when the variance is so big”.

But I would say that over the last six months, this average, well the variances tend to decrease and countries tend to converge much more than they have done in many years - both at national level, in countries like Portugal, Ireland and countries that are not in the programme, like Spain and Italy.

So now you are on pins and needles. What exactly is he talking about? What convergence? Convergence to Ireland's unemployment rate? The answer:

The progress in undertaking deficit control, structural reforms has been remarkable. And they will have to continue to do so. But the pace has been set and all the signals that we get is that they don’t relent, stop reforming themselves. It’s a complex process because for many years, very little was done – I will come to this in a moment.

No problem with convergence of structual reforms, although I sense he expects a more rapid positive economic response than is reasonable. More important is his focus on deficit convergence. This persistent belief in expansionary austerity will remain the Achilles heal in any European forecast. It guarantees the public sector will continue to deleverage as the private sector deleverages. This is a long-term negative for the Eurozone.

Failure to recognize the the negative weigh of austerity. Strike four. More:

But a lot of progress has been done at supranational level. That’s why I always say that the last summit was a real success. The last summit was a real success because for the first time in many years, all the leaders of the 27 countries of Europe, including UK etc., said that the only way out of this present crisis is to have more Europe, not less Europe.

A Europe that is founded on four building blocks: a fiscal union, a financial union, an economic union and a political union. These blocks, in two words – we can continue discussing this later – mean that much more of what is national sovereignty is going to be exercised at supranational level, that common fiscal rules will bind government actions on the fiscal side.

Then in the banking union or financial markets union, we will have one supervisor for the whole euro area. And to show that there is full determination to move ahead and these are not just empty words, the European Commission will present a proposal for the supervisor in early September. So in a month. And I think I can say that works are quite advanced in this direction.

Failure to understand that "fiscal union" in the European context is an "austerity union," not the supernational agency with broad tax and transfer powers that represents a real "fiscal union." Strike five. Failure to understand that the time it takes for Europe to reach a decision is vastly different than the speed at which markets react. Strike six.

Draghi than appeals to the permanence of the Euro:

But the third point I want to make is in a sense more political.

When people talk about the fragility of the euro and the increasing fragility of the euro, and perhaps the crisis of the euro, very often non-euro area member states or leaders, underestimate the amount of political capital that is being invested in the euro.

And so we view this, and I do not think we are unbiased observers, we think the euro is irreversible. And it’s not an empty word now, because I preceded saying exactly what actions have been made, are being made to make it irreversible.

I find this hilarious because it seems to me that the most vocal advocate of the idea that the Eurozone is not permanent is the force behind the Euro, the Germans, who so frequently voice the opinion that Greece is a lost cause. But I don't think it should be a strike against Draghi; he really sees the project is irreversible, which speaks, in theory, to his willingness to ultimately embrace the role of the ECB as a lender of last resort. With that in mind:

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.

The "within our mandate" condition is strike seven. The 2% inflation target is another factor that will be a weight on the European economy. See Paul Krugman. Draghi continues:

There are some short-term challenges, to say the least. The short-term challenges in our view relate mostly to the financial fragmentation that has taken place in the euro area. Investors retreated within their national boundaries. The interbank market is not functioning. It is only functioning very little within each country by the way, but it is certainly not functioning across countries.

And I think the key strategy point here is that if we want to get out of this crisis, we have to repair this financial fragmentation.

There are at least two dimensions to this. The interbank market is not functioning, because for any bank in the world the current liquidity regulations make - to lend to other banks or borrow from other banks - a money losing proposition. So the first reason is that regulation has to be recalibrated completely.

The second point is in a sense a collective action problem: because national supervisors, looking at the crisis, have asked their banks, the banks under their supervision, to withdraw their activities within national boundaries. And they ring fenced liquidity positions so liquidity can’t flow, even across the same holding group because the financial sector supervisors are saying “no”.

So even though each one of them may be right, collectively they have been wrong. And this situation will have to be overcome of course.

I see the financial fragmentation as a longer-run challenge. Indeed, this is really the factor that is preventing the effective transmission of monetary policy, not the interest rate on Spanish debt. And the history of financial crisis is that you cannot simply flip a switch and normal lending activity will resume. Moreover, ECB actions have almost certainly aggravated the challenges. Tying the banks to sovereign debt via the LTRO funding and then failing to serve as a lender of last resort to eliminate default risk certainly didn't do the banks any favors. More to the point, the ECB encouraged the financial fragmentation by letting the crisis fester to this point and not recognizing the lack of social and economic cohesion in the Eurozone (see above). If the collective action was wrong, it was because the individual actions were reacting to poor ECB policy.

Failure to understand their role in perpetuating the crisis. Strike nine.

And then there is a risk aversion factor. Risk aversion has to do with counterparty risk. Now to the extent that I think my counterparty is going to default, I am not going to lend to this counterparty. But it can be because it is short of funding. And I think we took care of that with the two big LTROs where we injected half a trillion of net liquidity into the euro area banks. We took care of that.

Then you have the counterparty recess related to the perception that my counterparty can fail because of lack of capital. We can do little about that.

Then there’s another dimension to this that has to do with the premia that are being charged on sovereign states borrowings. These premia have to do, as I said, with default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty - they come into our mandate. They come within our remit.

I am going to focus on the sovereign debt issue. Draghi breaks it into two parts, default and convertibility. Presumably, convertibility is the risk that Euro-denominated debt will be converted into debt denominated in a revived national currency. He seems to be saying that that can deal with the convertibility risk because it represents the willingess of investors to believe the Euro is not permanent. But is is permanent, he just said so. But I don't think it is the convertibility issue is at play. I think that investors genuinely fear default, and that such default will be driven by the ECB's failure to serve as lender of last resort. So that Spanish default is possible even if Spain remains in the ECB. Much like Greek default was possible.

I think the commitment to serving as lender of last resort might be different than commitment to the Euro alone. In other words, what Draghi is thinking of delivering may fall short of what markets are expecting at this point. Which would be consistent with European policy to date, and with the tone of Draghi's remarks - policymakers always think they are taking big steps, but they are so far behind the curve market participants see baby steps at best.

Bottom Line: Yes, I am a Euroskeptic, so feel free to take my comments with a grain of salt. Discount as appropiate. But when I read Draghi's remarks, I see a policymaker in denial, not wanting to understand the root causes of the crisis. Thus he sees the crisis in terms of simply lack of confidence rather than one with important fundamental factors. Moreover, he is trapped by the austerity framework, not seeing that this is a failing strategy. I don't think he sees the ECB's complicity in supporting the crisis. And I think Draghi is representative of the average policymaker in Europe. Which leaves me still convinced that Europe's future is either Depression or continued recession/stagnation. The ECB can prevent the former, but lacking a complete overhaul of the implications of protracted fiscal austerity and a "fiscal union" the cements such austerity in place, coupled with a serverely damaged financial system, I am challenged to see how the latter can be overcome.

Sunday, July 29, 2012

Internal Devaluation, Inflation, and the Euro (Wonkish), by Paul Krugman: I’ve been writing for a long time about how the euro area needs more inflation. But I suspect that many readers don’t quite see how this ties into the macro story. So here’s something that may or may not clear things up — a stylized little model linking euro inflation and the adjustment problem to overall monetary policy. It’s very stylized, making some obviously untrue but I think still useful assumptions, and I have been finding that it clarifies my own thinking ...[continue reading]...

Michael Hiltzik says the Simpson/Bowles deficit reduction plan is "really a guide to cutting services and benefits for the working and middle class while protecting the interests of the wealthy":

Deficit debate driven by the wealthy, by Michael Hiltzik, Commentary, LA Times: ...The fiscal cliff is supposedly what lurks at the end of this year, when billions of dollars in tax cuts expire and government spending cuts mandated by the big deficit deal in 2011 kick in. According to the bipartisan Congressional Budget Office, the combination of a steep increase in the tax bite and a steep reduction in spending across the board could cut economic growth in 2013 to 0.5% from a projected 4.4%... The CBO says that by any traditional reckoning, that would mean recession.

Only a political structure in the grip of hopeless insanity would allow that to happen. That's why the Washington observer class still expects Democrats and Republicans to reach a deal eventually...

Yet there's still reason for most Americans to fear the deal-making aimed at avoiding the fiscal cliff. For one thing, the debate seems increasingly to be driven by the wealthy, who can be trusted to protect their own prerogatives while declaring everyone else's to be wasteful. Just two weeks ago, a squadron of CEOs and bankers, including Dimon and hedge fund billionaire Pete Peterson, lined up behind a campaign to impose adult supervision on our squabbling Congress.

Their working brief is a document grandiosely entitled "The Moment of Truth."It's a deficit-reduction plan cooked up by former Sen. Alan Simpson (R-Wyo.) and Erskine Bowles, an ex-investment banker claiming Democratic Party cred from his nearly two-year stint as chief of staff in the Clinton White House. ...

In any environment of serious debate, Simpson-Bowles would be dismissed out of hand. ... "The Moment of Truth" bills itself as a roadmap to deficit reduction, but it's really a guide to cutting services and benefits for the working and middle class while raising revenues only modestly, if that. ...

After a big tax increase on high incomes, people should have an especially strong incentive to give money to good causes: to the needy and to schools, colleges, hospitals, churches, the arts and other purposes. Many such donations reduce the need for government spending, so the deduction isn’t terribly costly to the government. It is also likely to bring entrepreneurial creativity to such causes.

Of course, there are counterarguments: that few people are motivated to work for money that will largely have to be given away, and that it’s natural for people to want to make their families better off from their earnings. But there is an answer to that line of thinking: after one attains a certain level of comfort, greater wealth arguably contributes only to social status, which philanthropy certainly bolsters.

That’s a good reason for national policies that encourage philanthropy. Although it’s natural for people to want high social status, there are ways for high achievers to reach the same relative rank without so much wasteful conspicuous consumption...

Unfortunately, much talk today focuses on just the opposite idea: curtailing the charitable deduction for high-income people, in order to help close the federal deficit. ...

Amid rising concern about inequality, we should focus on how we can improve our tax code and other rules to encourage positive feelings of reciprocity in our society. And we can do it while still giving people incentives to innovate — and to keep working hard.

What Draghi Didn’t Do, by Paul Krugman: ...it’s now widely hoped that the ECB will start buying government bonds (although it’s not at all clear whether the Germans will allow this, particularly on a sufficient scale); this has caused a significant decline in Spanish interest rates from their peak.

Limiting interest rates on peripheral borrowing is, however, only part of what the euro needs. ...Europe also needs sufficiently high inflation over the next few years to make it possible for Spain etc. to regain competitiveness without devastating deflation. So have market expectations of inflation risen from their unworkably low levels of recent months? No:

Friday, July 27, 2012

Our Summer of Climate Truth, by Jeff Sachs, Commentary, Project Syndicate: ...When the temperature is especially high, or rains are especially heavy or light, scientists try to assess whether the unusual conditions are the result of long-term climate change or simply reflect expected variability. So, is the current US heat wave (making this the hottest year on record), the intense Beijing flooding, or the severe Sahel drought a case of random bad weather, or merely the result of long-term, human-induced climate change?

For a long time, scientists could not answer such a question precisely. They were unsure whether a particular weather disaster could be attributed to human causes, rather than to natural variation. ...

Several studies in the past year have shown that scientists can indeed detect long-term climate change in the rising frequency of extreme events – such as heat waves, heavy rains, severe droughts, and strong storms. By using cutting-edge climate models, scientists are not only detecting long-term climate change, but also are attributing at least some of the extreme events to human causes. ...

The evidence is solid and accumulating rapidly. Humanity is putting itself at increasing peril through human-induced climate change. ... Yet politicians everywhere are timid, especially because oil and coal companies are so politically powerful. Human well-being, even survival, will depend on scientific evidence and technological know-how triumphing over shortsighted greed, political timidity, and the continuing stream of anti-scientific corporate propaganda.

Money for Nothing, by Paul Krugman, Commentary, NY Times: For years, allegedly serious people have been issuing dire warnings about the consequences of large budget deficits — deficits that are overwhelmingly the result of our ongoing economic crisis. In May 2009, Niall Ferguson of Harvard declared that the “tidal wave of debt issuance” would cause U.S. interest rates to soar. In March 2011, Erskine Bowles, the co-chairman of President Obama’s ill-fated deficit commission, warned that unless action was taken on the deficit soon, “the markets will devastate us,” probably within two years. And so on.

Well, I guess Mr. Bowles has a few months left. But a funny thing happened on the way to the predicted fiscal crisis: instead of soaring, U.S. borrowing costs have fallen to their lowest level in the nation’s history. ...

So what is going on? The main answer is that this is what happens when you have a “deleveraging shock,” in which everyone is trying to pay down debt at the same time. Household borrowing has plunged; businesses are sitting on cash because there’s no reason to expand capacity when the sales aren’t there... So they’re buying government debt, even at very low returns, for lack of alternatives. Moreover, by making money available so cheaply, they are in effect begging governments to issue more debt.

And governments should be granting their wish, not obsessing over short-term deficits.

Obligatory caveat: yes, we have a long-run budget problem, and we should be taking steps to address that problem, mainly by reining in health care costs. But it’s simply crazy to be laying off schoolteachers and canceling infrastructure projects at a time when investors are offering zero- or negative-interest financing.

You don’t even have to make a Keynesian argument about jobs to see that. All you have to do is note that when money is cheap, that’s a good time to invest. And both education and infrastructure are investments in America’s future; we’ll eventually pay a large and completely gratuitous price for the way they’re being savaged.

That said, you should be a Keynesian, too. The experience of the past few years — above all, the spectacular failure of austerity policies in Europe — has been a dramatic demonstration of Keynes’s basic point: slashing spending in a depressed economy depresses that economy further.

So it’s time to stop paying attention to the alleged wise men who hijacked our policy discussion and made the deficit the center of conversation. They’ve been wrong about everything — and these days even the financial markets are telling us that we should be focused on jobs and growth.

It looks like Draghi finally found that panic button. This is crucial, as the ECB is the only institution that can bring sufficient firepower to the table in a timely fashion. His specific reference to the disruption in policy transmission appears to be a clear signal that the ECB will resume purchases of periphery debt, presumably that of Spain and possibly Italy. The ECB will - rightly, in my opinion - justify the purchases as easing financial conditions not monetizing deficit spending.

So far, so good. But there is enough in these statements to leave me very unsettled. First, the claim that the Euro is "irreversible" should send a shiver down everyone's backs. Sounds just a little too much like "the crisis is contained to subprime" and "Spain will not need a bailout." Second, the bluster that "believe me, it will be enough" is suspect. The ECB always thinks they have done enough, but so far this has not been the case. Moreover, he is setting some pretty high expectations, and had better be prepared to meet them with something more than half-hearted bond purchases.

Also, note that despite Draghi's bluster, the rally in Spanish debt send yields just barely below the 7% mark. A step in the right direction, but also a signal that investors still worry that Spain will need a bailout despite additional ECB action.

More distressing to me was Draghi's clearly defiant tone, reminiscent of comments earlier this week from German Finance Minister Wolfgang Schäuble. The message is that Europe has done all the right things, it is financial market participants that are doing the wrong things. What we have here is a failure to communicate. European leaders believe they have made remarkable progress in the context of the political realities they face, and want credit for that expended "political capital." Financial markets are saying the the progress politicians see as "remarkable" barely moves the needle compared to what is necessary to resolve the crisis.

The classic breakup line is "it's not you, it's me." It is a classic line because everyone knows it's a lie. I suppose at least Draghi is living up to the lie, essentially saying that "it's not me, it's you." European policy makers simply will not accept what financial markets are telling them. As a consequence, Draghi doesn't act until his back is against the wall, they engage in some half-hearted program, conditions ease temporarily, and then the ECB drifts back into the woodwork, claiming they have done all they can do. Lather, rinse, repeat. Why should we believe this time is any different?

As to the claims of Euro-area strength, Isabella Kaminska has this to say:

The second thing we think is interesting is Draghi’s point that the euro area is much stronger than people realise. This *we think* is very encouraging indeed. And whilst many might disagree, we actually don’t think it’s a bluff at all. Not only does it tie very much with Draghi’s previous comments about how well Ireland is doing, it suggests Draghi feels the market may be over focusing on the wrong metrics. Or, in other words, that there may be other economic gauges that are much more reflective of what’s really going on.

I don't usually disagree with the FT Alphaville staff, but I disagree on this point. I don't find it encouraging at all. I think it is exactly the kind of delusion that leads to spectacular policy failure. I can't wait for the ECB to pull out the statistics that explain exactly how we don't get it. I want to see the explanation of how this reflects the strength of the European economy:

Call me crazy, but I get a little disconcerted when unemployment rates exceed 11%. And, is it just me, or isn't the gap between the Eurozone and EU27 rates increasing, suggesting that being a member of the Eurozone is on net a negative?

And what about the lasting impact of this crisis? I get unnerved by the structural damage due to Washington's acceptance of 8+% unemployment rates in the US. That is absolutely trivial compared to Europe. Spain is at 24.6%, with a a youth unemployment rate of 52.1%. We called this a Great Depression in the 1930's, not a sign of strength. Greece was at 21.9% in March. France and Italy are in the double digit range. And the "remarkable" Ireland has an unemployment rate at 14.6%. Simply put, the mindless pursuit of fiscal consolidation is scarring a generation of workers, perhaps irrevocably. There will be a cost that offsets the benefits of the structural change European leaders seem intent on pursuing in the absence of fiscal stimulus.

Also, how much damage is being done to the European financial system? Gillian Tett reports on the fracturing of banking along national boundaries:

The bankers, however, were alarmingly precise: amid all the speculation about Grexit, they told me, banks are increasingly reordering their European exposure along national lines, in terms of asset-liability matching (ALM), just in case the region splits apart. Thus, if a bank has loans to Spanish borrowers, say, it is trying to cover these with funding from Spain, rather than from Germany. Similarly, when it comes to hedging derivatives and foreign exchange deals, or measuring their risk, Italian counterparties are treated differently from Finnish counterparties, say.

The halcyon days of banks looking on the eurozone as a single currency bloc are over; cross-border risk matters. To put it another way, while pundits engage in an abstract debate about a possible break-up, fracture has already arrived for many banks’ risk management departments, at least when it comes to ALM in their eurozone books.

The way this is heading is toward a continent with limited cross-border capital flows with a fiscal policy regime that limits members ability to use fiscal policy, all under a single monetary policy. This is a recipe for long-term recession, not economic strength. And it is also a system that will become increasingly susceptible to asymmetric shocks.

Finally, note that we are well past the point where just bringing down interest rates in peripheral economies is enough to turn the ship around. The 10-year UK bond yield stands at 1.48% today. And despite low rates, the UK economy continues to struggle:

The UK’s double-dip recession has deepened sharply and unexpectedly, leaving the economy smaller than it was when the coalition government took office two years ago....

...critics of Mr Osborne’s austerity programme, which aims to eliminate the structural current deficit in five years, said the data showed his efforts were self-defeating.

“As we warned two years ago, David Cameron and George Osborne’s ill-judged plan has turned Britain’s recovery into a flatlining economy and now a deep and deepening recession,” said Ed Balls, shadow chancellor for the Labour party.

In short, it's not just about interest rates.

Bottom Line: Draghi has his back up against the wall, and is now forced to step back into the crisis. A near-term positive, to be sure. It might be a longer-term positive if the ECB would commit to an open-ended purchase program based on macroeconomic objectives (sound familar?). But that is likely too much to ask, as he has yet to admit that the entire policy approach is failing the Eurozone, not just in the short-run, but in the long-run as well. Until policymakers fundamentally rethink their approach to the crisis, expect the optimisim-pessimism cycle to continue. Right now, the best case scenario I see is that the ECB will act to hold the Eurozone largely together, but at the cost of protracted recession.

Mathew Yglesias discusses a dispute about whether recovery from the recession would have been faster if we had provided more help for households, and less help for banks:

This gets us to the actual dispute. Team Tim [Geithner] would say that they're trying to create a well-capitalized banking system in order to bolster the broader economy. Team Neil [Barofsky] counters that the broader economy would be better-served by a policy that imposed steep losses on banks and instead repaired household balance sheets. Beneath all the anger and accusations and counter-accusations is a fairly wonky policy disagreement about the relative importance of household balance sheets versus the credit channel to laying the preconditions for growth.

Here's my take (from December 2010). As others have noted, we needed to help both banks and households, and it didn't have to be one or the other. But there was no need to bail out banks directly, at least not on the scale that it was done, banks could have been helped indirectly by helping households:

...recovery from these “balance sheet recessions” is notoriously slow. As households rebuild their balance sheets, resources are directed away from consumption, and the reduction in aggregate demand is a drag on the economy. It takes a long time for households to recover what is lost, and the recovery will be slow so long as this rebuilding process continues. Fiscal policy attempts to restore the lost aggregate demand, and that is important, but it does very little to directly address the household balance sheet issue.

The same cannot be said about bank balance sheets. The effect on bank balance sheets also varies with the type of recession, and a financial collapse brought about by bad loans is particularly severe. The present recession is an example of this, and policy has done a good job of preventing even worse problems from developing by rebuilding financial sector balance sheets through the bank bailout and other means.

But household balance sheets have not received as much attention. We could have helped households rebuild their balance sheets, and this would have helped banks by lowering the default rate on loans. Instead, we left households to mostly solve their problems on their own, and then helped banks when households could not repay what they owed.

When a balance sheet recession hits, one of the keys to a quick recovery is to use the federal government’s balance sheet as a means of offsetting the deterioration in the private sector’s financial position. But we shouldn’t just focus on banks. Household balance sheet problems are every bit as severe, and in total every bit as systemically important as the balance sheet problems of banks. We’ll recover faster from balance sheet recessions if we pay attention to all private sector balance sheets instead of focusing mainly on the problems of banks.

To be more concrete, the government could have given households help in the form of a voucher that could only be used to repay loans (e.g. mortgage, student loan, or credit card debt incurred prior to this program). Banks still get the money they need to stay liquid and solvent, but households get help at the same time (an alternative, and what we essentially did, is to write off the loans and foreclose, etc. on households, then give the banks money to offset the losses). There are still political problems associated with using taxpayer money to bail out people with bad credit, so how the program is designed would be important (for example, there might be less objection to helping people who are having difficulties due to job loss from the recession, but are otherwise decent credit risks), but the point is that helping banks does not require handing them money. The help can be funneled through the household sector allowing both sets of balance sheets to be rebuilt at the same time.

Bullard also dismisses financial market distress as an artifact of the European crisis:

The global problems are clearly being driven by continued turmoil in Europe.

China might be a bigger driver than we realize, but I digress. Given that this is a European problem, the Fed is helpless:

A change in U.S. monetary policy at this juncture will not alter the situation in Europe.

This is one of those things that makes you shake your head in the wonder of it all. The point of further easing would not be to alter the situation in Europe - THE POINT IS TO PREVENT THE SITUATION IN EUROPE FROM WASHING UP ON US SHORES.

Europe's deepening economic crisis is cutting into corporate earnings, with the continent's woes threatening to exert a drag on multinational corporations around the world into next year...

...The corporate alarm bells highlight how the miserable economic conditions in much of Europe are spilling onto the global stage. With much of Europe in recession and unemployment soaring, spending is sliding on everything from big-ticket items like cars to everyday staples like yogurt...

...Companies also are growing concerned about 2013 as government austerity measures eat into sales. The Ifo Institute survey of business sentiment released on Wednesday shows business confidence in Germany, Europe's largest economy, falling to its lowest level in over two years.

And note the trend in capital goods orders:

Flat growth year-over-year. Not necessarily a recession, but a clear warning sign as well. It is starting to look like firms satisfied their pent-up demand and don't see the underlying growth that justifies further spending. And clearly Europe is only aggravating that situation.

The recent softness in manufacturing is a warning sign that usually prompts Fed easing. That might be next week, or next month - there remains considerable uncertainty on the timing of their next move. But one thing is looking more certain day by day: The Fed should have been hitting their own panic button six weeks ago when it became clear their forecasts were well off the mark.

Casey Mulligan says that trying to help the poor "had the unintended consequence of deepening-if not causing-the recession." There was a financial crisis, but that wasn't the problem according to his story, and it wasn't the decline in housing wealth. Nope, everything would have been just fine (or at least "two to three times" better) if we had just let the poor struggle like they deserved:

Redistribution, or subsidies and regulations intended to help the poor, unemployed, and financially distressed, have changed in many ways since the onset of the recent financial crisis. The unemployed, for instance, can collect benefits longer and can receive bonuses, health subsidies, and tax deductions, and millions more people have became eligible for food stamps.

Economist Casey B. Mulligan argues that while many of these changes were intended to help people endure economic events and boost the economy, they had the unintended consequence of deepening-if not causing-the recession. ... The book ... reveals the startling amount of work incentives eroded by the labyrinth of new and existing social safety net program rules, and, using prior results from labor economics and public finance, estimates that the labor market contracted two to three times more than it would have if redistribution policies had remained constant. ...

We are also told that "...Casey B. Mulligan offers ... groundbreaking interpretations..." Groundbreaking? Perhaps, but there's a reason nobody else is suggesting these things. It may be groundbreaking, but it's also a dry hole.

Moving on to another ideologue, Arthur Laffer is attempting humor as well, though he gives the appearance of being quite serious:

Jeff Horwich: ...What's so wrong about raising taxes on this small segment of wealthy Americans, and lowering them or keeping them the same for other folks?

Laffer: The problem with raising taxes on rich people -- what they call rich people -- is rich people have many options open to them that other people don't have, and you won't get the money. You know, if you could get the money from them without costs, I'd love it. But you can't.

So the problem is that the rich are just too clever for the rest of us. If we try to tax them, they'll find a way to avoid it, so why even try? But wait, aren't Republicans constantly whining that the rich are paying more taxes than they used to (while ignoring how much their incomes have risen)? How did that happen if they are so clever at avoiding such things?

Later, he also asserts that tax increases pay for themselves despite a mountain of evidence pointing in the other direction:

Laffer: Yeah, a lot of common sense. Even if you did get more money from the top 1 percent, it would be more than offset by the losses other people would not pay in taxes because these people aren't employing as many people, aren't investing as much, aren't buying as much. I mean, it's much more than just one little group.

That's nonsense, there's no evidence that raising taxes from their current rates would decrease revenues even when such secondary effects -- which are small -- are accounted for.

How do you come to such conclusions? By ignoring the data when it disagrees with you:

Horwich: Many economists will say the data is extremely inconclusive in practice as to how marginal tax changes actually affect personal and business activity. What makes you so sure?

Laffer: Because basically, these economists you talk about never worked in the real world. They're just looking at the econometrics and the data there. ...

Horwich: But am I right that I just heard you criticize economists for actually looking at the data and making their decisions based on that?

Laffer: ...I think it's really silly to look at this aggregate data and not make any judgments beyond those aggregate data.

Finally, he is asked about inequality, but he never actually answers the question of how his center could have put out such a laughable report:

Horwich: Many other economists left, right and center will point to various kinds of data that show income and wealth inequality in the U.S. are increasing, maybe the worst in many, many years. And yet, your center just put out a report claiming to debunk this narrative on income inequality. Are you saying that's not true?

Laffer: You know, this is a debate that's going to go on for years and years and years. I don't mind inequality if people are rising in incomes in all groups. I do mind equality when everyone's brought down to the lowest common denominator. You don't want to make the rich poor; you want to make the poor richer. These inequality specialists all around the place aren't proposing that. In all the quest to achieve less inequality, they are creating equality by lowering everyone. And that's silly.

He makes it sound like this is a "debate," but the debate is over for those who can be swayed be evidence. Income inequality has been rising, and tax cuts for the wealthy -- which somehow didn't produce the wonderful economy the Laffers of the world promised us -- played a big role in redirecting income to the top.

After issuing the statement late yesterday, Schaeuble, 69, went off duty for a three-week vacation.

It’s summertime in Europe, and like last year, borrowing costs are rising as investors fret over the fate of the 17- nation euro area. Most government leaders are heading to their favorite beaches, mountains and lakes to take a break from a crisis that U.S. Treasury Secretary Timothy Geithner said July 23 requires “immediate, short-term” measures to help Spain and Italy.

This upshot of the article is that, like last summer, leadership will be hard to come by in Europe for the next month.

Brad DeLong wrote this piece on the costs of long-term unemployment in 1997. (For my taste, he does not put enough emphasis on public jobs programs to bridge the gap and prevent people from becoming tainted by long-term unemployment in the first place. If we had done more, much much more, for example, to find infrastructure projects with high labor intensity and put people to work on their construction, we would have far fewer long-term unemployed to worry about. The "slide into depression" would have been far shorter, and the climb out not quite as steep. The private sector still has to find a way to employ these workers itself at some point, but that is easier -- and the costs more equitably distributed -- when people have been employed, and increasing demand as they spend their incomes.)

Sliding Into The Great Depression: At its nadir, the Depression was collective insanity. Workers were idle because firms would not hire them to work their machines; firms would not hire workers to work machines because they saw no market for goods; and there was no market for goods because workers had no incomes to spend.

Long-term unemployment means that the burden of economic dislocation is unequally borne. Since the prices workers must pay often fall faster than wages, the welfare of those who remain employed frequently rises in a depression. Those who become and stay unemployed bear far more than their share of the burden of a depression. Moreover the reintegration of the unemployed into even a smoothly-functioning market economy may prove difficult, for what employer would not prefer a fresh entrant into the labor force to someone out of work for years? The simple fact that an economy has recently undergone a period of mass unemployment may make it difficult to attain levels of employment and boom that a luckier economy attains as a matter of course. Once an economy had fallen deeply into the Great Depression, devalued exchange rates, prudent and moderate government budget deficits (as opposed to the deficits involved in fighting major wars), and the passage of time all appeared equally ineffective ways of dealing with long-term unemployment. Highly centralized and unionized labor markets like Australia's and decentralized and laissez-faire labor markets like that of the United States did equally poorly in dealing with long-term unemployment. Fascist "solutions" were equally unsuccessful, as the case of Italy shows, unless accompanied by rapid rearmament as in Germany.

Even today, economists have no clean answers to the question of why the private sector could not find ways to employ its long-term unemployed. The very extent of persistent unemployment in spite of different labor market structures and national institutions suggests that theories that find one key failure responsible should be taken with a grain of salt.

But should we be surprised that the long-term unemployed do not register their labor supply proportionately strongly? They might accurately suspect that they will be at the end of every selection queue. In the end it was the coming of World War II and its associated demand for military goods that made private sector employers wish to hire the long-term unemployed at wages they would accept.

At first the unemployed searched eagerly and diligently for alternative sources of work. But if four months or so passed without successful reemployment, the unemployed tended to become discouraged and distraught. After eight months of continuous unemployment, the typical unemployed worker still searches for a job, but in a desultory fashion and without much hope. And within a year of becoming unemployed the worker is out of the labor market for all practical purposes: a job must arrive at his or her door, grab him or her by the scruff of the neck, and through him or her back into the nine-to-five routine if he or she is to be employed again.

This is the pattern of the long-term unemployed in the Great Depression; this is the pattern of the long-term unemployed in Western Europe in the 1990s. It appears to take an extraordinarily high-pressure labor market, like that of World War II, to successfully reemploy the long-term unemployed.

Thomas Palley emails to say that he thinks this "might be of interest to you and your readers":

More on the spurious victory claims of MMT: Led by Randy Wray (see this and this), supporters of so-called Modern Monetary Theory (MMT) are declaring that they were the first to identify the problems of the euro and that MMT has now proved itself to be the correct approach to monetary theory.

As regards these two claims, permit me to quote the following:

“5.3 Will capital still be able to veto policy? …First, financial capital may still be able to discipline governments through the bond market. Thus, if financial capital dislikes the stance of national fiscal policy, there could be a sell-off of government bonds and a shift into bonds of other countries. This would drive up the cost of government borrowing, thereby putting a break on fiscal policy (Palley, 1997, p.155-156).”

MMT is a mix of old and new. In my view, the old is widely understood by old Keynesians and the new is substantially wrong. The above quote from my 1997 paper shows two things:

(1) MMT’ers were not the first to predict the structural flaw in the euro’s design regarding possibilities for conduct of fiscal policy.

(2) Old Keynesians fully understood that if you remove the national central bank, national government is reduced to the status of a province and may be unable to run deficit based fiscal policy if bond markets refuse to finance it.

With regard to theoretical weaknesses, MMT lacks a convincing theory of interest rates, over-simplifies the economy by assuming an L-shaped supply schedule that ignores the effects of sectoral bottlenecks and imbalances, lacks an adequate theory of inflation, and ignores expectations and exchange rates. These omissions lead it to overstate the powers of monetary and fiscal policy.

In this regard, I offered an early critique of MMT in the context of its twin policy proposal for an employer of last resort (see Palley, 2001). I am not necessarily against an ELR. However, because of their reliance on MMT, supporters of ELR tend to oversell the proposal and ignore problems that may be considerable. This illustrates how the theoretical short-comings of MMT can promote dangerous over-simplifications of important and complex policy issues.

A lower value of the euro would reduce the prices of eurozone exports and raise the cost of imports, reducing or eliminating the current account deficits of the peripheral European countries... The weaker euro would also boost Germany’s net exports, raise German wages and prices and reduce the trade imbalance within the eurozone.

The increase in peripheral country net exports would also raise their gross domestic product and so reverse their recessions that were caused by higher taxes and cuts in government spending. That would make it politically easier to achieve the needed fiscal consolidations. And shifting from recession to growth would raise business incomes and employment, reducing the volume of bad loans and mortgage defaults now hurting the banks. ...

The continuing decline of the euro reflects the market’s perception that the euro must fall or the eurozone will collapse. ... The decline of the euro can therefore occur without specific action by the European Central Bank. But a further shift by the ECB toward a looser monetary policy would speed the euro’s decline. ...

I believe now, as I did 20 years ago, that imposing a single currency on a heterogeneous group of countries is a mistake. ... But while the creation of the eurozone was an economic mistake, allowing it to dissolve now would be very costly to governments, investors and citizens. ... A new start for the euro is still well worth trying.

First, sure enough, the self-reliant businessman featured in Romney’s ads was the beneficiary of large government loans and contracts. This doesn’t make him a bad guy; pretending that he did it all himself does.

And as many others have pointed out, what does it say about Romney’s campaign that to run against a sitting president, one with a three and a half year track record, they have to lie about what he said to find a point of attack? ...

Tuesday, July 24, 2012

Is There Even a Panic Button in Europe?, by Tim Duy: I didn't think it was possible, but my confidence in the ability of European policymakers to pull the Continent out of crisis continues to fall. This is saying a lot because I had virtually no confidence to begin with.

Consider where we are at today. Greece once again is making the headlines, as it is increasingly evident that they have made virtually no progress on the last bailout package, and will therefore need another. This should have come as no surprise; it was increasingly politically impossible to engage in additional austerity with the Greek economy plummeting into the abyss. But bailout fatigue will finally hit this time, as there appears to be no more appetite to limp Greece along. Evan Ambrose-Pritchard argues that Germany is leading the drive to finally force Greece out of the Eurozone. Ambrose rightly places at least some, if not the lion's share, of the blame for this outcome at the feet of the Troika:

This was entirely predictable – and was predicted by many critics – since Greece faced an IMF-style austerity package without the usual IMF cure of devaluation. The Troika's ideology of "expansionary fiscal contraction" – which the IMF has to its credit since abjured, but the fanatics in charge still swear by – is breaking a whole society on the wheel.

The Greeks were never given a bailout plan that had any hope of success. And they deserved such a bailout, given the rest of Europe's culpability in this crisis for letting Greece into the Euro in the first place.

Whether or not Greece can be forced from the Euro with little impact elsewhere remains to be seen. I doubt we will need to wait much longer to learn the outcome of Grexit. But the devastating train that is the debt crisis keeps rolling right along, currently crashing through Spain's economy.

And make no mistake, European policymakers have learned nothing from the Greek experience. One gets the sense that policymakers think the prescription was correct, but that the patient was simply unwilling to take the medicine. Where Greece failed, Spain will succeed, or at least so it is hoped. Indeed, today Spanish Finance Minister Luis de Guindos met with his German counterpart, and the FT reports:

Germany on Tuesday threw its considerable weight behind the reform and austerity programme of the Spanish government, in the face of a continuing surge in the cost of borrowing for Madrid, and strong protests against its spending cuts.

Spain is doing the right thing, apparently. It's just the markets that have it all wrong:

A joint statement by Wolfgang Schäuble, German finance minister, and Luis de Guindos, Spanish economy minister, condemned the high interest rates demanded for the sale of Spanish bonds as failing to reflect “the fundamentals of the Spanish economy, its growth potential and the sustainability of its public debt”.

The truth is exactly the opposite - market participants have looked at Spain's fiscal and economic situation, including the issue of provincial bailouts, and concluded that another sovereign bailout is coming, complete with private sector involvement. The "voluntary" kind of involvement, of course. And in return for this bailout, Spain will be pushed further down the same path of never ending recession as Greece. Because if once you don't succeed, try, try again. European policymakers will pursue the same path because they know of no other:

But after talks in Berlin last night on the eurozone crisis, the two gave no hint of any new initiatives to try to calm the markets, or prevent contagion from Spain affecting any other members of the eurozone, such as Italy.

This comes as Spanish 10 year yields hit 7.62% and the Italian equivalent lurches up to 6.60%. And unbelievably, the ECB is apparently out of the game, no longer willing to buy sovereign debt either to avoid being a victim of "public sector bailout" or because they believe that restrictions against monetizing the debt of member states trump imminent financial collapse. Meanwhile, the crisis is increasingly bleeding through to the supposedly immune German economy, with the Markit PMI continuing to fall. The deeper Europe slides into recession, the harder it will be to find solutions.

And it is already almost near impossible to find solutions, a fact proved by the seemingly pointless European summits that always seem to come too late and offer too little.

Yet despite what is obviously clear and present danger to the Eurozone project, and, more importantly than the project, but to the economy on which millions depend for their livelihood, there doesn't seem to be any panic in official circles. No sense that policies need to be fundamentally reassessed. No sense that time is of the essence. No one is even bothering to leak unsubstantiated and false rumors of some "Grand Plan" in the works.

In my view, the lack of panic is downright scary. Is Europe completely devoid of new ideas? Or is everyone simply on vacation?

Bottom Line: Still a Euroskeptic, and an increasingly pessimistic one at that. I really, really want to believe that Europe will quickly coalesce around a solution to the crisis, and I hope to see a move in that direction soon. At a minimum, the ECB should throw in the towel and backstop sovereign debt. But all I see are the same failed policies again and again. Worse, no one is running for the panic button. Maybe there isn't a panic button; I guess it was another piece of the necessary institutional framework forgotten during the creation of the Euro.

Avent is less impressed than me on Williams' conversion to open-ended QE as a policy tool because it by itself does not communicate a willingness to allow inflation to exceed 2%. I think that Avent is on the right path. While Williams did make what I think is a big step, he could go one step further and not only call for open-ended QE, but to do so in the context of Chicago President Charles Evans' suggestion for explicitly tolerating inflation up to 3%. That said, I also think this is too much to hope for, as I haven't seen any indication that Williams would be willing to deviate from the 2% target.

Also, you can interpret open-ended QE as a higher possibility that the Federal Reserve will not be able to pull-back the increase in the money supply, thus one could expect higher inflation in the future. And by leaving the program as open-ended, you remove the uncertainty created by arbitrary end dates and purchase amounts. So I do think that Williams is making a significant shift in the right direction. But I agree with Avent that a clear communication of tolerance for higher inflation would be even more effective.

Ultimately, I think the Federal Reserve made a huge policy error in committing to an explicit 2% inflation target. I think policymakers were under the impression that such a commitment would give them more flexibility by removing concerns that QE would be inflationary. In reality, I think it had the opposite effect - it eliminated a policy tool, thereby reducing their flexibility. And that commitment stands as a barrier to Evans' suggested policy path. I think the rest of the Fed would loathe accepting inflation as high as 3% given they just committed to 2% at the beginning of this year. In doubt, they would view such backtracking as a threat to their much-cherished credibility.

Interestingly, they don't see Treasury rates below 1.4% as a threat to their credibility. They really should.

An abundance of credibility allows the Fed to bring the inflation rate down from, for example, 5 percent to 2 percent at minimal cost to the economy. It also makes it less likely that inflation will become a problem in the first place, because high credibility makes long-run inflation expectations less sensitive to temporary spells of inflation. So maintaining high credibility has substantial benefits.

Does this mean the Fed should do its best to keep the inflation rate at 2 percent?

Sticking to a 2 percent target independent of circumstances is not optimal. There are times, such as now, when allowing the inflation rate to drift above target would help the economy. Higher inflation during a recession encourages consumers and businesses to spend cash instead of sitting on it, it reduces the burden of pre-existing debt, and it can have favorable effects on our trade with other countries.

If inflation begins to rise before the recovery is complete the Fed could, for example, announce that it is willing to allow the inflation rate to stay above target temporarily in the interest of helping the economy. But once unemployment hits a pre-set rate, for example 6.25 percent, or core inflation rises above some predetermined threshold, for example, 5 percent, then, and only then, will the Fed step in and take action. ...

So no disagreement here, except that I would set the limit even higher than 3 percent inflation since I am not at all worried about the Fed's long-run credibility on inflation. As I noted, "I have no doubt that, once the economy has finally recovered, the Fed will ensure that the inflation rate is near its target value, so long-run credibility is not at risk."

One further note: I have asked Federal Reserve officials directly why the 2% inflation target is treated as a ceiling rather than a central value, and have been assured that it is, in fact, a central value (so that inflation should fluctuate around the target value instead of staying at or below target as it would if the target is a ceiling). But the data suggests otherwise -- the errors have been mostly one-sided (i.e. inflation has generally been below target). Even if the Fed is unwilling to raise the target, it should at least tolerate enough of a rise in the inflation rate to get two-sided errors, but it hasn't even been willing to do that.

I Know the Congressional Culture of Corruption, by Jack Abramoff: ...No one would seriously propose visiting a judge before a trial and offering a financial gratuity, or choice tickets to an athletic event, in exchange for special consideration from the bench. Yet no inside-the-Beltway hackles are raised when a legislative jurist -- also known as a congressman -- receives a campaign contribution even as he contemplates action on an issue of vital importance to the donor.

During the years I was lobbying, I purveyed millions of my own and clients' dollars to congressmen, especially at such decisive moments. I never contemplated that these payments were really just bribes, but they were. Like most dissembling Washington hacks, I viewed these payments as legitimate political contributions, expressions of my admiration of and fealty to the venerable statesman I needed to influence.

Outside our capital city (and its ever-prosperous contiguous counties), the campaign contributions of special interests are rightly seen as nothing but bribes. The purposeful dissonance of the political class enables congressmen to accept donations and solemnly recite their real oath of office: My vote is not for sale for a mere contribution. They are wrong. Their votes are very much for sale, only they don't wish to admit it. ...

Press Release: Europe is on the threshold of catastrophe. The euro zone’s fault lines are readily apparent and the interaction between markets, inadequate institutions, and the unsustainable political conditions in many countries is driving the European economy toward depression and the euro zone toward disintegration.

It is with a sense of urgency and a desire to overcome these dangerous conditions that The Institute for New Economic Thinking (INET) sponsored the formation of the INET Council on the Euro Zone Crisis (ICEC) that is comprised of 17 leading European economists. (list of members). The group held its first meeting on June 26-27 in Brussels and a nonstop virtual meeting has taken place since then.

As the pressures toward disintegration of the euro increase and the deep social unrest in Spain, Italy, and other countries erupts, the INET Council of the Euro zone members felt compelled to issue a brief report that creates a vision of how the euro zone could be repaired and redesigned at this desperate juncture.

The report recognizes that there has been little overlap between what is economically and financially necessary to repair the flaws in the euro zone system and what is politically feasible in an environment that has degenerated into distrust among nations within the system. It is in that context that the ICEC has recommended the following:

1. This dramatic situation is the result of a euro zone system that is thoroughly broken. This systemic failure exacerbated a boom in capital flows and credit, and complicated its aftermath after the boom turned to bust.

2. It is the responsibility of all European nations that were parties to the euro’s flawed design, construction, and implementation to contribute to a solution.

3. Absent a collective effort the euro zone will disintegrate quickly. The stresses have been building for a long time and conditions in several countries are not socially or politically sustainable much longer.

4. In formulating recommendations, the ICEC report makes a clear distinction between the legacy problems that were created by the dysfunctional design of the euro zone over the past 10 years and the challenges of re-design that would restore the soundness of the Euro zone system.

5. One cannot deal with the legacy overhangs as long there is no clear commitment to long-term re-design.

6. At the same time it is impossible to build long-term mechanisms such as a banking union as long as the legacy overhang of debt imbalances debt, competitiveness, and capital inadequacy of financial institutions impede the path toward a healthy Europe.

See the report for more detail on the recommendations. The ICEC will meet next in the early fall to examine scenarios that include disintegration of the Euro zone and its ramifications, a realignment of the Euro zone into two blocs, and the role of the United Kingdom in the future of Europe.

Monday, July 23, 2012

Robert Shiller argues that reining in markets is not the answer to bubbles:

Bubbles without Markets, by Robert Shiller, Commentary, Project Syndicate: A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes... The excitement then lures more and more people into the market ... in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy.

But, before we conclude that we should now, after the crisis, pursue policies to rein in the markets, we need to consider the alternative. In fact, speculative bubbles are just one example of social epidemics, which can be even worse in the absence of financial markets. In a speculative bubble, the contagion is amplified by people’s reaction to price movements, but social epidemics do not need markets or prices to get public attention and spread quickly.

Some examples of social epidemics unsupported by any speculative markets can be found in Charles MacKay’s 1841 best seller Memoirs of Extraordinary Popular Delusions and the Madness of Crowds.The book made some historical bubbles famous: the Mississippi bubble 1719-20, the South Sea Company Bubble 1711-20, and the tulip mania of the 1630’s. But the book contained other, non-market, examples as well.

MacKay gave examples, over the centuries, of social epidemics involving belief in alchemists, prophets of Judgment Day, fortune tellers, astrologers, physicians employing magnets, witch hunters, and crusaders. Some of these epidemics had profound economic consequences. The Crusades from the eleventh to the thirteenth century, for example... Between one and three million people died in the Crusades.

There was no way, of course, for anyone either to invest in or to bet against the success of any of the activities promoted by the social epidemics – no professional opinion or outlet for analysts’ reports on these activities. So there was nothing to stop these social epidemics from attaining ridiculous proportions. ...

The recent and ongoing world financial crisis pales in comparison with these events. And it is important to appreciate why. Modern economies have free markets, along with business analysts with their recommendations, ratings agencies with their classifications of securities, and accountants with their balance sheets and income statements. And then, too, there are auditors, lawyers and regulators.

All of these groups have their respective professional associations, which hold regular meetings and establish certification standards that keep the information up-to-date and the practitioners ethical in their work. The full development of these institutions renders really serious economic catastrophes – the kind that dwarf the 2008 crisis – virtually impossible.

Setting aside the extent to which these are really bubbles as commonly understood, nobody is talking about eliminating markets entirely. The push from those of us who want to "rein in the markets" is to regulate them so they function better than they did prior to the crisis. I don't see how these examples of so called non-market bubbles argue against regulating markets to make them work better. Modern economies may have something like the "free markets" Shiller talks about, but unregulated markets do not always function in the public's best interest and regulations that rein them in and make them more competitive, less subject to catastrophic failure, etc. can improve their social value. The question isn't about markets versus non-markets, the question is how to make our existing insitutions perform better and none of the above helps much with that question. How, for example, can we make business analysts, ratings agencies, accountants, lawyers, and regulators that Shiller lauds -- all of whom fell down on the job to some extent prior to the crisis -- do a better job next time?

Finally, I can't help asking: What is his definition of "really serious catastrophe"? How many millions of unemployed does it take? I'd hate to see a crisis that "dwarfs" this one, but this was no walk in the park. Perhaps the crowd Shiller hangs around in didn't think it was all that serious, but for many, many people it was quite catastrophic.

Update: I should have also added that the fact that this recession, while severe, didn't reach the depths of the Great Depression has more to do with improved social insurance, better automatic stabilizers, better policy (though far from perfect), and a higher initial level of wealth than it does the presence of free markets, business analysts, ratings agencies, accountants, auditors, lawyers, and regulators.

Why would the United States, which now devotes 40% of its corn crop to the production of ethanol, import more than 4 billion gallons of ethanol from Brazil? And why would Brazil at the same time import a projected 2 billion gallons from the U.S.? Couldn’t we just save all those transactions costs and shipping-related greenhouse gas emissions by keeping our ethanol and cutting our projected ethanol imports from Brazil in half?

Not if your goal is to game the U.S. biofuel mandate.

The U.S. Renewable Fuel Standard, passed in 2007 and known as RFS2, includes a mandate for 36 billion gallons of renewable fuel use by 2022, with a nested set of mandates for different types of biofuels. Conventional or first-generation biofuels, such as ethanol from corn, have limited environmental benefits, with supposed reductions in greenhouse gas (GHG) emissions of about 20%. Congress wisely set the mandate such that the majority of the 36 billion-gallon mandate should be met by “advanced biofuels” with a GHG score of 50% or better in terms of reductions.

Well, advanced biofuel production in the United States isn’t going so well. ... At this point, all we produce is a whole lot of corn ethanol, and we are already nearing the technical limit of 15 billion gallons for non-advanced biofuels.

Fortunately for Brazilian ethanol producers..., the renewable fuel mandate can be met to a significant extent by the use of “other” advanced biofuels. Even though Congress was sold the RFS on the promise of energy independence, those “other biofuels” do not have to be produced in the United States. (In fact, mandating U.S. sourcing could have been subject to a WTO challenge.) Brazil’s sugarcane-based ethanol is considered advanced, with a GHG-reduction score of 50% despite widespread concerns about a range of other social and environmental impacts. ...

Under the FAO-OECD’s baseline scenario, Brazil would import 2 billion gallons of corn ethanol from the United States. Why, if it’s a major ethanol exporter and it produces more environmentally sustainable ethanol? To make up for the domestic shortfall created by its exports to the U.S., and to meet its own rising demand from its expanding fleet of flex-fuel cars. They’ll take our low-grade corn ethanol if they can get a higher price for their sugar-based equivalent.

Talk about perverse. It’s bad enough that we meet our environmental goals not through good old American know-how but by buying it from someone else. Then we turn around and sell them an environmentally inferior equivalent at a cheaper price.

In the process, another round in the food-fuel fight will be won by the fuels, with ethanol demand continuing to put upward pressure on corn prices globally. The FAO-OECD report contains strong warnings on biofuels’ impacts on food prices, and it went to press even before drought parched the U.S. corn belt. They projected stable or slightly declining prices in 2012 and forward. Instead, corn and soybean prices are hitting historic highs and the world is staring down the loaded barrels of the third major spike in commodities prices in the last five years.

Unfortunately, the powers that be seem to have learned nothing from the first two. They certainly haven’t learned that it’s still a bad idea to put food in our cars.

And beyond the "perverse" influence of the powers behind biofuels, Paul Krugman notes the corrupting influence of Big Oil and Big Coal:

VSPs of Energy: David Roberts has an interesting post about how the “experts” massively underestimated the potential for growth in renewable energy: wind and solar have grown enormously faster than the Very Serious People, energy sector, predicted circa 2000. He links this to the somewhat related tendency of the alleged experts to predict huge costs from efforts at energy conservation, huge costs that keep on not materializing.

Roberts suggests that it’s because conventionally-minded experts aren’t in touch with the potential of technologies that are (a) new and (b) distributed, representing choices by millions of players as opposed to a few big corporations.

Maybe. But I’d place more emphasis on a more cynical view: capture, both crude and subtle, by existing fossil-fuel interests (with nuclear power, another big business venture, somewhat similar).

It should be obvious that Big Oil and Big Coal have a stake in having the public believe that there is no alternative to ever more drilling, digging, and burning. And who employs, funds, and generally shapes the careers of mainstream energy “experts”? Who actually has a seat at the table when international organizations are putting together their scenarios?

It doesn’t have to be raw corruption, although there’s that too. It can instead be a matter of creating a mindset. And a lot of that mindset involves the sense that serious, hard-headed men think in terms of big extractive projects, that solar, wind, and conservation are hippie stuff — a sense that persists even in the teeth of contrary evidence.

And this banal observation may be what dooms us to climate catastrophe, in two ways. On one side, the variability of temperatures ... makes it easy to miss, ignore or obscure the longer-term upward trend. On the other, even a fairly modest rise in average temperatures translates into a much higher frequency of extreme events — like the devastating drought now gripping America’s heartland — that do vast damage. ...

How should we think about the relationship between climate change and day-to-day experience? Almost a quarter of a century ago James Hansen, the NASA scientist..., suggested the analogy of loaded dice. Imagine ... representing the probabilities of a hot, average or cold summer by historical standards as a die with two faces painted red, two white and two blue. By the early 21st century,... it would be as if four of the faces were red, one white and one blue. Hot summers would become much more frequent, but there would still be cold summers now and then.

And so it has proved..., 9 of the 10 hottest years on record have occurred since 2000. But that’s not all: really extreme high temperatures ... have now become fairly common. Think of it as rolling two sixes, which happens ... more often when the dice are loaded. And this rising incidence of extreme events ... means that the costs of climate change aren’t a distant prospect, decades in the future. On the contrary, they’re already here...

The great Midwestern drought is a case in point. This drought has already sent corn prices to their highest level ever..., it could cause a global food crisis... And yes, the drought is linked to climate change: such events have happened before, but they’re much more likely now than they used to be.

Now, maybe this drought will break in time to avoid the worst. But there will be more events like this. ... Will the current drought finally lead to serious climate action? History isn’t encouraging. The deniers will surely keep on denying... And the public is all too likely to lose interest again the next time the die comes up white or blue.

But let’s hope that this time is different. For large-scale damage from climate change is no longer a disaster waiting to happen. It’s happening now.

1.) There will be little progress in the labor market in the absence of additional policy. Not surprising, given that the Fed's forecasts were never exactly exciting to begin with, and the recent weakness in the data flow is leading economists to downgrade Q2 growth to the 1% range, putting even the Fed's anemic forecasts into jeopardy.

2.) Williams believes the Fed should shift the focus to mortgage backed securities:

“There’s a lot more you can buy without interfering with market function and you maybe get a little more bang for the buck,” he said.

He sees MBS as an avenue around the potentially disruptive effects of additional Treasury purchases, acknowledging one of the concerns about additional QE.

3.) Importantly, Williams realizes that the arbitrary end-dates for policy actions are disruptive and counterproductive. Instead, he argues for open-ended purchases:

“The main benefit from my point of view is it will get the markets to stop focusing on the terminal date [when a programme of purchases ends] and also focusing on, ‘Oh, are they going to do QE3?’” he said. Instead, markets would adjust their expectation of Fed purchases as economic conditions changed.

This is a big step, and, in my opinion, this is exactly where the Fed needs to go. Shift the focus from the policy itself to the macroeconomic outcomes the policy is trying to achieve. After two years of stop-start policy, Williams gets it.

4.) Eliminating interest on reserves is pretty much off the table. I never thought the Fed was too excited about the this option.

5.) Despite delivering a strong argument for QE, Williams himself is not convinced the FOMC will follow his lead:

But he declined to call directly for a Fed move. “I think the argument against further action is the question of uncertainty around the effects, the costs and the benefits of doing so,” he said.

This uncertainty was evident in the minutes of the last FOMC meeting, as well as Federal Reserve Chairman Ben Bernanke's trip to Capitol Hill last week. While I would like to think that his generally dour outlook was in and of itself a signal that he was prepared to ease further, he made clear that QE was not the only option on the table. As quoted by the FT:

“We haven’t really come to a specific choice at this point, but we are looking for ways to address the weakness in the economy should more action be needed to promote a sustained recovery in the labour market.”

This makes me think that there is not broad support at the FOMC for additional QE, or, what I increasingly think is likely, that Bernanke himself is sufficiently uncertain about the impact of additional QE that he would prefer to find another tool, perhaps with the idea of reserving QE for a more dire situation. If Bernanke wanted to push the FOMC in the direction of QE, he could have done it well before now. Thus, the fact that such internal uncertainty remains about what the Fed would do next reveals something about his preferences.

Bottom Line: Williams again telegraphs his belief that the Fed should engage in additional quantitative easing, and makes a big step in calling for an open-ended program. It is not, however, clear the Bernanke has come to the same conclusion. It's really Bernanke, not the Fed hawks, that has been the impediment to further easing.

Sunday, July 22, 2012

The fiscal cliff and rationality by Jim Hamilton: ...Let's begin by acknowledging the obvious: the United States faces a very significant long-run issue of fiscal solvency...-- if historical policies remain in effect for the next 15 years we are going to be in real trouble. There is no ambiguity about the fact that medical expenditures have been rising much faster than other categories, and that the American population is going to continue to age. The historical combination of existing tax rates and the rising federal role in health care is unquestionably unsustainable.

Although I emphatically agree that America needs to make changes today that change the fundamentals of those long-term trends, I do not think it is necessary to do so with immediate tax increases or spending cuts. As Karl Smith observes, with the current negative real yields on government debt, the government is actually making a profit by running a budget deficit... Granted, we've seen some of the European countries move ... to ... needing to pay very high interest costs very quickly in response to rapid shifts in investor sentiment. The U.S. would face an enormous problem if the same kind of debt flight were to hit our Treasury auction. That's one of the reasons why I think it's extremely important to put in place today policies that permanently change the long-term fundamentals, but whose fiscal bite increases only gradually over time. ...

However... Existing law tries to make the transition all at once with very significant tax increases and spending cuts. These are scheduled to be implemented at the end of this year, a situation that some refer to as "America's fiscal cliff." The tax increases and spending cuts ... sum to over $600 B in fiscal year 2013, a figure that represents about 4% of total GDP...

How big an effect this would have on the economy depends on the fiscal multiplier. ... But even if the multiplier were significantly less than 1, a 4% hit to government spending and consumer purchasing power, in an economy that is struggling to keep the growth rate above 2%, would be enough by itself to put the U.S. economy into recession. ...

What do I expect is actually going to happen? I propose that the key question to focus on is this: in whose interest would it be to see the U.S. go off the fiscal cliff into recession?

The clear answer is: no one's. Democrats don't want to see that happen, nor do Republicans. The logical thing to expect is therefore that somehow they'll figure out a way to modify existing law before January 1, postponing the lion's share of the tax increases and spending cuts for at least another year. ... But the cumbersome process of getting to that outcome will once again exact its own unique toll.

My priors place more weight on bad outcomes than his appear to do, in part because I don't see the political incentives as closely aligned as he does.

Saturday, July 21, 2012

Charles Plosser, President of the Philadelphia Fed, explains the limitations of DSGE models, particularly models of the New Keynesian variety used for policy analysis. (He doesn't reject the DSGE methodology, and that will disappoint some, but he does raise good questions about this class of models. I believe the macroeconomics literature is going to fully explore these micro-founded, forward looking, optimizing models whether critics like it or not, so we may as well get on with it. The questions raised below help to clarify the direction the research should take, and in the end the models will either prove worthy, or be cast aside. In the meantime, I hope the macroeconomics profession will become more open to alternative ideas/models than it has been in the recent past, but I doubt the humility needed for that to happen has taken hold despite all the problems with these models that were exposed by the housing and financial crises.):

More than 40 years ago, the rational expectations revolution in macroeconomics helped to shape a consensus among economists that only unanticipated shifts in monetary policy can have real effects. According to this consensus, only monetary surprises affect the real economy in the short to medium run because consumers, workers, employers, and investors cannot respond quickly enough to offset the effect of these policy actions on consumption, the labor market, and investment.1

But over the years this consensus view on the transmission mechanism of monetary policy to the real economy has evolved. The current generation of macro models, referred to as New Keynesian DSGE models,2 rely on real and nominal frictions to transmit not only unanticipated but also systematic changes in monetary policy to the economy. Unexpected monetary shocks drive movements in output, consumption, investment, hours worked, and employment in DSGE models. However, in contrast to the earlier literature, it is the relevance of systematic movements in monetary policy that makes these models of so much interest for policy analysis. Systematic policy changes are represented in these models by Taylor-type rules, in which the policy interest rate responds to changes in inflation and a measure of real activity, such as output growth. Armed with forecasts of inflation and output growth, a central bank can assess the impact that different policy rate paths may have on the economy. The ability to do this type of policy analysis helps explain the widespread use of New Keynesian DSGE models at central banks around the world.

These modern macro models stress the importance of credibility and systematic policy, as well as forward-looking rational agents, in the determination of economic outcomes. In doing so, they offer guidance to policymakers about how to structure policies that will improve the policy framework and, therefore, economic performance. Nonetheless, I think there is room for improving the models and the advice they deliver on policy options. Before discussing several of these improvements, it is important to appreciate the “rules of the game” of the New Keynesian DSGE framework.

The New Keynesian Framework

New Keynesian DSGE models are the latest update to real business cycle, or RBC, theory. Given my own research in this area, it probably does not surprise many of you that I find the RBC paradigm a useful and valuable platform on which to build our macroeconomic models.3 One goal of real business cycle theory is to study the predictions of dynamic general equilibrium models, in which optimizing and forward-looking consumers, workers, employers, and investors are endowed with rational expectations. A shortcoming many see in the simple real business cycle model is its difficulty in internally generating persistent changes in output and employment from a transitory or temporary external shock to, say, productivity.4 The recognition of this problem has inspired variations on the simple model, of which the New Keynesian revival is an example.

The approach taken in these models is to incorporate a structure of real and nominal frictions into the real business cycle framework. These frictions are placed in DSGE models, in part, to make real economic activity respond to anticipated and unanticipated changes in monetary policy, at least, in the short to medium run. The real frictions that drive internal propagation of monetary policy often include habit formation in consumption, that is, how past consumption influences current consumption; the costs of capital used in production; and the resources expended by adding new investment to the existing stock of capital. New Keynesian DSGE models also include the costs faced by monopolistic firms and households when setting their prices and nominal wages. A nominal friction often assumed in Keynesian DSGE models is that firms and households have to wait a fixed interval of time before they can reset their prices and wages in a forward-looking, optimal manner. A rule of the game in these models is that the interactions of these nominal frictions with real frictions give rise to persistent monetary nonneutralities over the business cycle.5 It is this monetary transmission mechanism that makes the New Keynesian DSGE models attractive to central banks.

An assumption of these models is that the structure of these real and nominal frictions, which transmit changes in monetary policy to the real economy, well-approximate the true underlying rigidities of the actual economy and are not affected by changes in monetary policy. This assumption implies that the frictions faced by consumers, workers, employers, and investors cannot be eliminated at any price they might be willing to pay. Although the actors in actual economies probably recognize the incentives they have to innovate — think of the strategy to use continuous pricing on line for many goods and services — or to seek insurance to minimize the costs of the frictions, these actions and markets are ruled out by the “rules of the game” of New Keynesian DSGE modeling.

Another important rule of the game prescribes that monetary policy is represented by an interest rate or Taylor-type reaction function that policymakers are committed to follow and that everyone believes will, in fact, be followed. This ingredient of New Keynesian DSGE models most often commits a central bank to increase its policy rate when inflation or output rises above the target set by the central bank. And this commitment is assumed to be fully credible according to the rules of the game of New Keynesian DSGE models. Policy changes are then evaluated as deviations from the invariant policy rule to which policymakers are credibly committed.

The Lucas Critique Revisited with Respect to New Keynesian DSGE Models

In my view, the current rules of the game of New Keynesian DSGE models run afoul of the Lucas critique — a seminal work for my generation of macroeconomists and for each generation since.6 The Lucas critique teaches us that to do policy analysis correctly, we must understand the relationship between economic outcomes and the beliefs of economic agents about the policy regime. Equally important is the Lucas critique’s warning against using models whose structure changes with the alternative government policies under consideration.7 Policy changes are almost never once and for all. So, many economists would argue that an economic model that maps states of the world to outcomes but that does not model how policy shifts across alternative regimes would fail the Lucas critique because it would not be policy invariant.8 Instead, economists could better judge the effects of competing policy options by building models that account for the way in which policymakers switch between alternative policy regimes as economic circumstances change.9

For example, I have always been uncomfortable with the New Keynesian model’s assumption that wage and price setters have market power but, at the same time, are unable or unwilling to change prices in response to anticipated and systematic shifts in monetary policy. This suggests that the deep structure of nominal frictions in New Keynesian DSGE models should do more than measure the length of time that firms and households wait for a chance to reset their prices and wages.10 Moreover, it raises questions about the mechanism by which monetary policy shocks are transmitted to the real economy in these models.

I might also note here that the evidence from micro data on price behavior is not particularly consistent with the implications of the usual staggered price-setting assumptions in these models.11 When the real and nominal frictions of New Keynesian models do not reflect the incentives faced by economic actors in actual economies, these models violate the Lucas critique’s policy invariance dictum, and thus, the policy advice these models offer must be interpreted with caution.

From a policy perspective, the assumption that a central bank can always and everywhere credibly commit to its policy rule is, I believe, also questionable. While it is desirable for policymakers to do so — and in practice, I seek ways to make policy more systematic and more credible — commitment is a luxury few central bankers ever actually have, and fewer still faithfully follow.

During the 1980s and 1990s, it was quite common to hear in workshops and seminars the criticism that a model didn’t satisfy the Lucas critique. I thought this was often a cheap shot because almost no model satisfactorily dealt with the issue. And during a period when the policy regime was apparently fairly stable — which many argued it mostly was during those years — the failure to satisfy the Lucas critique seemed somewhat less troublesome. However, in my view, throughout the crisis of the last few years and its aftermath, the Lucas critique has become decidedly more relevant. Policy actions have become increasingly discretionary. Moreover, the financial crisis and associated policy responses have left many central banks operating with their policy rate near the zero lower bound; this means that they are no longer following a systematic rule, if they ever were. Given that central bankers are, in fact, acting in a discretionary manner, whether it is because they are at the zero bound or because they cannot or will not commit, how are we to interpret policy advice coming from models that assume full commitment to a systematic rule? I think this point is driven home by noting that a number of central banks have been openly discussing different regimes, from price-level targeting to nominal GDP targeting. In such an environment where policymakers actively debate alternative regimes, how confident can we be about the policy advice that follows from models in which that is never contemplated?

Some Directions for Furthering the Research Agenda

While I have been pointing out some limitations of DSGE models, I would like to end my remarks with six suggestions I believe would be fruitful for the research agenda.

First, I believe we should work to give the real and nominal frictions that underpin the monetary propagation mechanism of New Keynesian DSGE models deeper and more empirically supported structural foundations. There is already much work being done on this in the areas of search models applied to labor markets and studies of the behavior of prices at the firm level. Many of you at this conference have made significant contributions to this literature.

Second, on the policy dimension, the impact of the zero lower bound on central bank policy rates remains, as a central banker once said, a conundrum. The zero lower bound introduces nonlinearity into the analysis of monetary policy that macroeconomists and policymakers still do not fully understand. New Keynesian models have made some progress in solving this problem,12 but a complete understanding of the zero bound conundrum involves recasting a New Keynesian DSGE model to show how it can provide an economically meaningful story of the set of shocks, financial markets, and frictions that explain the financial crisis, the resulting recession, and the weak recovery that has followed. This might be asking a lot, but a good challenge usually produces extraordinary research.

Third, we must make progress in our analysis of credibility and commitment. The New Keynesian framework mostly assumes that policymakers are fully credible in their commitment to a specified policy rule. If that is not the case in practice, how do policymakers assess the policy advice these models deliver? Policy at the zero lower bound is a leading example of this issue. According to the New Keynesian model, zero lower bound policies rely on policymakers guiding the public’s expectations of when an initial interest rate increase will occur in the future. If the credibility of this forward guidance is questioned, evaluation of the zero lower bound policy has to account for the public's beliefs that commitment to this policy is incomplete. I have found that policymakers like to presume that their policy actions are completely credible and then engage in decisions accordingly. Yet if that presumption is wrong, those policies will not have the desired or predicted outcomes. Is there a way to design and estimate policy responses in such a world? Can reputational models be adapted for this purpose?

Fourth, and related, macroeconomists need to consider how to integrate the institutional design of central banks into our macroeconomic models. Different designs permit different degrees of discretion for a central bank. For example, responsibility for setting monetary policy is often delegated by an elected legislature to an independent central bank. However, the mandates given to central banks differ across countries. The Fed is often said to have a dual mandate; some banks have a hierarchal mandate; and others have a single mandate. Yet economists endow their New Keynesian DSGE models with strikingly uniform Taylor-type rules, always assuming complete credibility. Policy analysis might be improved by considering the institutional design of central banks and how it relates to the ability to commit and the specification of the Taylor-type rules that go into New Keynesian models. Central banks with different levels of discretion will respond differently to the same set of shocks.

Let me offer a slightly different take on this issue. Policymakers are not Ramsey social planners. They are individuals who respond to incentives like every other actor in the economy. Those incentives are often shaped by the nature of the institutions in which they operate. Yet the models we use often ignore both the institutional environment and the rational behavior of policymakers. The models often ask policymakers to undertake actions that run counter to the incentives they face. How should economists then think about the policy advice their models offer and the outcomes they should expect? How should we think about the design of our institutions? This is not an unexplored arena, but if we are to take the policy guidance from our models seriously, we must think harder about such issues in the context of our models.

This leads to my fifth suggestion. Monetary theory has given a great deal of thought to rules and credibility in the design of monetary policy, but the recent crisis suggests that we need to think more about the design of lender-of-last-resort policy and the institutional mechanism for its execution. Whether to act as the lender of last resort is discretionary, but does it have to be so? Are there ways to make it more systematic ex ante? If so, how?

My sixth and final thought concerns moral hazard, which is addressed in only a handful of models. Moral hazard looms large when one thinks about lender-of-last-resort activities. But it is also a factor when monetary policy uses discretion to deviate from its policy rule. If the central bank has credibility that it will return to the rule once it has deviated, this may not be much of a problem. On the other hand, a central bank with less credibility, or no credibility, may run the risk of inducing excessive risk-taking. An example of this might be the so-called “Greenspan put,” in which the markets perceived that when asset prices fell, the Fed would respond by reducing interest rates. Do monetary policy actions that appear to react to the stock market induce moral hazard and excessive risk-taking? Does having lender-of-last-resort powers influence the central bank’s monetary policy decisions, especially at moments when it is not clear whether the economy is in the midst of a financial crisis? Does the combination of lender-of-last-resort responsibilities with discretionary monetary policy create moral hazard perils for a central bank, encouraging it to take riskier actions? I do not know the answer to these questions, but addressing them and the other challenges I have mentioned with New Keynesian DSGE models should prove useful for evaluating the merits of different institutional designs for central banks.

Conclusion

The financial crisis and recession have raised new challenges for policymakers and researchers. The degree to which policy actions, for better or worse, have become increasingly discretionary should give us pause as we try to evaluate policy choices in the context of the workhorse New Keynesian framework, especially given its assumption of credibly committed policymakers. Indeed, the Lucas critique would seem to take on new relevance in this post-crisis world. Central banks need to ask if discretionary policies can create incentives that fundamentally change the actions and expectations of consumers, workers, firms, and investors. Characterizing policy in this way also raises issues of whether the institutional design of central banks matters for evaluating monetary policy. I hope my comments today encourage you, as well as the wider community of macroeconomists, to pursue these research questions that are relevant to our efforts to improve our policy choices.

Another quick one while I wait for a connection at the SF airport --- Robert Stavins explains the independence property for cap-and-trade systems. This property "allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs":

Two Notable Events Prompt Examination of an Important Property of Cap-and-Trade, by Robert Stavins: ...In our just-published article, “The Effect of Allowance Allocations on Cap-and-Trade System Performance,” [Robert] Hahn and I ... focused on an idea that is closely related to the Coase theorem, namely, that the market equilibrium in a cap-and-trade system will be cost-effective and independent of the initial allocation of tradable rights (typically referred to as permits or allowances). That is, the overall cost of achieving a given emission reduction will be minimized, and the final allocation of permits will be independent of the initial allocation, under certain conditions (conditional upon the permits being allocated freely, i.e., not auctioned). We call this the independence property. It is closely related to a core principle of general equilibrium theory (Arrow and Debreu 1954), namely, that when markets are complete, outcomes remain efficient even after lump-sum transfers among agents.

The Practical Political Importance of the Independence Property

We were interested in the independence property because of its great political importance. The reason why this property is of such great relevance to the practical development of public policy is that it allows equity and efficiency concerns to be separated. In particular, a government can set an overall cap of pollutant emissions (a pollution reduction goal) and leave it up to a legislature to construct a constituency in support of the program by allocating shares of the allowances to various interests, such as sectors and geographic regions, without affecting either the environmental performance of the system or its aggregate social costs. Indeed, this property is a key reason why cap-and-trade systems have been employed and have evolved as the preferred instrument in a variety of environmental policy settings.

In Theory, Does the Property Always Hold?

Because of the importance of this property, we examined the conditions under which it is more or less likely to hold — both in theory and in practice. In short, we found that in theory, a number of factors can lead to the independence property being violated. These are particular types of transaction costs in cap-and-trade markets; significant market power in the allowance market; uncertainty regarding the future price of allowances; conditional allowance allocations, such as output-based updating-allocation mechanisms; non-cost-minimizing behavior by firms; and specific kinds of regulatory treatment of participants in a cap-and-trade market.

I encourage you to read our article, but, a quick summary of our assessment is that we found modest support for the independence property in the seven cases we examined (but also recognized that it would surely be useful to have more empirical research in this realm).

Politicians Have Had it Right

That the independence property appears to be broadly validated provides support for the efficacy of past political judgments regarding constituency building through legislatures’ allowance allocations in cap-and-trade systems. Governments have repeatedly set the overall emissions cap and then left it up to the political process to allocate the available number of allowances among sources to build support for an initiative without reducing the system’s environmental performance or driving up its cost.

This success with environmental cap-and-trade systems should be contrasted with many other public policy proposals for which the normal course of events is that the political bargaining that is necessary to develop support reduces the effectiveness of the policy or drives up its overall cost. So, the independence property of well-designed and implemented cap-and-trade systems is hardly something to be taken for granted. It is of real political importance and remarkable social value.

Christina Romer says, in reference to health care costs, that "serious debate over further cost-savings measures may be a long way off" because "Republicans seem more interested in just limiting the government’s share of health care expenditures than in slowing overall spending":

Don’t get me wrong: the new law is a great step forward. It is expected to expand health insurance coverage to more than 30 million uninsured Americans without increasing the deficit, and it makes an important start on reining in the rapid growth of health care costs. ...

Just how much the law will slow spending growth is highly uncertain. The Congressional Budget Office, whose views on this issue fall squarely between the optimists’ and the pessimists’, estimates that it’s likely to reduce the budget deficit by about $1 trillion in its second decade — when the cost-containment measures have had time to pay dividends.

Big as those savings are, they will still leave a huge share of national output dedicated to health care and the federal budget far in the red. ...

Sadly, serious debate over further cost-savings measures may be a long way off. Some Republicans seem more interested in just limiting the government’s share of health care expenditures than in slowing overall spending. And some Democrats seem more interested in just preserving existing government programs than in making the entire health care system more efficient.

For the sake of the nation’s fiscal health, and the health and economic security of American families, it’s time to embrace cost containment in health care as the next great legislative challenge.

[The article details the cost-saving measures in the health care legislation, and discusses further steps that could be taken, but shies away from any suggestion that we adopt the types of universal care health care systems that have worked to contain costs in other countries.]

The first is the relationship between extreme weather events and climate change. The normal, cautious thing is to say that there’s no way to attribute any particular event, like a heat wave in the Ukraine, to global warming — and news media have basically been bullied by this argument into rarely mentioning climate change even when reporting on extreme weather. But Hansen et al make an important point: this argument is much weaker when we’re talking about really extreme events, like temperatures more than 3 standard deviations above historical norms. Such events would almost never happen if there weren’t a rising trend in global temperatures; so when they become quite common, as they have, it’s fair to call them evidence of warming.

The second point is how we know that climate change is a bad thing — a question I sometimes get asked. The questioners wonder why the fact that, say, more of Canada becomes agriculturally viable doesn’t offset the damage in places that get too hot.

My first-pass answer is that we have a global economy that is adapted to historically normal climate — not just in terms of what is grown where, but in terms of where we locate our cities. In the long run, after a couple of centuries’ worth of urban development and infrastructure has been drowned by rising sea levels and/or made useless because previously habitable regions need to be abandoned, we might be able to reconstruct an equally productive economy; but in the long run …

But Hansen et al make a stronger point: life as we know it evolved to fit the historical range of planetary temperatures. In the long run it might be able to adapt to a changed world — but now we’re talking millions of years.

I thought some of these agencies performed much better in the past, e.g. during the Clinton administration. In any case, what seems to be missing from this account is the role of the Republican attack on government (beyond the push for privatization discussed below):

Regulatory thrombosis, by Daniel Little: Charles Perrow is a leading researcher on the sociology of organizations, and he is a singular expert on accidents and system failures. Several of his books are classics in their field... So it is very striking to find that Perrow is highly skeptical about the ability of governmental organizations in the United States to protect the public from large failures and disasters of various kinds -- hurricanes, floods, chemical plant fires, software failures, terrorism. His assessment of organizations such as the Federal Emergency Management Agency, the Department of Homeland Security, or the Nuclear Regulatory Commission is dismal. ...

The level of organizational ineptitude that he documents in the performance of these agencies is staggering... And the disarray that he documents in these organizations is genuinely frightening. ...

What this all suggests is that the U.S. government and our political culture do a particularly bad job of creating organizational intelligence in response to crucial national challenges. By this I mean an effective group of bureaus with a clear mission, committed executive leadership, and consistent communication and collaboration among agencies and a demonstrated ability to formulate and carry out rational plans in addressing identified risks. ... And the US government's ability to provide this kind of intelligent risk abatement seems particularly weak.

Perrow doesn't endorse the general view that organizations can never succeed in accomplishing the functions we assign to them -- hospitals, police departments, even labor unions. Instead, there seem to be particular reasons why large regulatory agencies in the United States have proven particularly inept, in his assessment. The most faulty organizations are those that are designed to regulate risky activities and those that are charged to create prudent long-term plans for the future that seem particularly suspect, in his account. So what are those reasons for failure in these kinds of organizations?

One major part of his assessment focuses on the role that economic and political power plays in deforming the operations of major organizations to serve the interests of the powerful. Regulatory agencies are "captured" by the powerful industries they are supposed to oversee, whether through influence on the executive branch or through merciless lobbying of the legislative branch. Energy companies pressure the Congress and the NRC to privatize security at nuclear power plants -- with what would otherwise be comical results when it comes to testing the resulting level of security at numerous plants. Private security forces are given advance notice of the time and nature of the simulated attack -- and even so half the attacks are successful.

Another major source of dysfunction that Perrow identifies in the case of the Department of Homeland Security is the workings of Congressional politics..., the funds available through Homeland Security become a major prize for lobbyists, corporations, and other interested parties -- with resulting congressional pressure on DHS strategies and priorities.

Another culprit in this story of failure is the conservative penchant for leaving everything to private enterprise. As Michael Brown put the point during his tenure as director of FEMA, “The general idea—that the business of government is not to provide services, but to make sure that they are provided—seems self-evident to me” (kl 1867). ... Activities like nuclear power generation, chemical plants, air travel, drug safety, and residential development in hurricane or forest fire zones are all too risky to be left to private initiative and self-regulation. We need strong, well-resourced, well-staffed, and independent regulatory systems for these activities, and increasingly our scorecard on each of these dimensions is in the failing range.

Overall it appears that Perrow believes that agencies like DHS and FEMA would function better if they were under clear authority of the executive branch rather than Congressional oversight and direction. Presidential authority would not guarantee success -- witness George W. Bush's hapless management of the first iteration of Homeland Security within the White House -- but the odds are better. With a President with a clearly stated and implemented priority for effective management of the risk of terrorism, the planning and coordination needed would have a greater likelihood of success.

It often sounds as though Perrow is faulting these organizations for defects that are inherent in all large organizations. But it seems more fair to say that his analysis does not identify a general feature of organizations that leads to failure in these cases, but rather a situational fact having to do with the power of business to resist regulation and the susceptibility of Congress and the President to political pressures that hamstring effective regulatory organizations. Perrow does refer to specific organizational hazards -- bad executive leadership, faltering morale, inability to collaborate across agencies, excessively hierarchical architecture -- but the heart of his argument lies elsewhere. The key set of problems spiral back to the inordinate power that corporations have in the United States, and the distortions they create in Congress and the executive branch. ... It is specifics of the US political system rather than general defects of large organizations per se that lead to the bad outcomes that Perrow identifies. There are strong democracies that do a much better job of regulating risky industries and planning for disasters than we do -- for example, France and Germany. ...

There isn't much public concern about these risks, and legislators are therefore free to ignore them as well. ... So where will the political demand for strong regulation come from? Will we need to wait for the bad news we've managed by good fortune to have avoided up to this point?

Friday, July 20, 2012

This should be default liberal position. Recommended RT @MarkThoma: The Problem Isn't Outsourcing... - Robert Reich

However, for my taste, Reich gives in too much to the idea that income flows over the last several decades have followed changes in productivity. But they haven't, increases in the productivity of labor have not translated into corresponding increases in real wages, the gains have gone to the top of the income distribution instead, and it's not clear to me how calling for more a more competitive, more productive workforce will change that. Of course we want labor to be more competitive and more productive, but we also want workers to be rewarded when this happens:

These are the dog days of summer and the silly season of presidential campaigns. But can we get real, please? The American economy has moved way beyond outsourcing abroad or even “in-sourcing.” Most big companies headquartered in America don’t send jobs overseas and don’t bring jobs here from abroad. That’s because most are no longer really “American” companies. They’ve become global networks that design, make, buy, and sell things wherever around the world it’s most profitable for them to do so.

As an Apple executive told the New York Times, “we don’t have an obligation to solve America’s problems. Our only obligation is making the best product possible.” ...

What’s going on? Put simply, America isn’t educating enough of our people well enough to get American-based companies to do more of their high-value added work here. ... Transportation and communication systems abroad are also becoming better and more reliable. In case you hadn’t noticed, American roads are congested, our bridges are in disrepair, and our ports are becoming outmoded.

So forget the debate over outsourcing. The way we get good jobs back is with a national strategy to make Americans more competitive — retooling our schools, getting more of our young people through college or giving them a first-class technical education, remaking our infrastructure, and thereby guaranteeing a large share of Americans add significant value to the global economy.

But big American-based companies aren’t pushing this agenda, despite their huge clout in Washington. They don’t care about making Americans more competitive. They say they have no obligation to solve America’s problems. ...

The core problem isn’t outsourcing. It’s that the prosperity of America’s big businesses – which are really global networks that happen to be headquartered here – has become disconnected from the well-being of most Americans.

Mitt Romney’s Bain Capital is no different from any other global corporation — which is exactly why Romney’s so-called “business experience” is irrelevant to the real problems facing most Americans.

Without a government that’s focused on more and better jobs, we’re left with global corporations that don’t give a damn.